Suppose you’re a homeowner with a hideous master bathroom. You’d like to remodel, but you don’t see how you can afford it. According to HomeAdvisor, the average cost for that job is around $9,400, and there’s no way you can squeeze that amount out of your budget right now.
Then, one day, you get a letter from your bank offering you the chance to open a home equity line of credit (HELOC). It explains that this is a way to tap into the value of your home for cash. The letter says you could borrow up to $30,000 this way, for only 5% interest.
At first glance, this looks like the solution to all your problems. But you hesitate, thinking there must be a catch. Is borrowing against your home this way a good idea? Before you rush down to the bank, you need to understand exactly how a HELOC works and what the pros and cons are. Here’s everything you need to know to make a wise financial decision.
How HELOCs Work
When you take out a home equity line of credit, you’re borrowing money from the bank with your home as collateral. HELOCs are different from other types of home loans because you don’t borrow a fixed amount and pay it back over time. Instead, a HELOC gives you access to a pool of cash that you can dip into as needed.
Like a credit card, a HELOC is a revolving loan. You can borrow any amount up to the credit limit. Then you can pay all or part of the balance back – like paying your credit card bill – and draw it down again. In other words, the size of the loan can expand and contract to fit your needs.
However, unlike a credit card, a HELOC usually comes with a time limit. You can only draw out money for a certain period, typically 5 to 10 years. This is known as the “draw period.” During the draw period, your monthly payments are for the interest on the loan only.
With some HELOCs, as soon as the draw period ends, the entire balance comes due. Whatever you still owe has to be paid back right away in a lump sum. However, most HELOCs have a “repayment period” of 10 to 20 years. During this time, you make regular payments of principal and interest until the loan is paid off.
A HELOC is sometimes called a “second mortgage,” because it’s an additional loan you can take out on a house that already has a mortgage. However, this term is misleading. Most HELOCs are second mortgages, but you can also take out a HELOC on a home that’s fully paid off. And, on the other hand, it’s possible to take out a second mortgage that’s a fixed-term loan – usually called a home equity loan – rather than a line of credit.
Reasons to Use a HELOC
Homeowners most often use HELOCs to pay for home renovations or repairs. Using a HELOC this way makes sense, because many home improvements add value to your home. If you use the money wisely, you could come out ahead when you sell the house.
However, homeowners also use HELOCs for many other needs – some wiser than others. For instance, they could take out a HELOC to:
- Pay for college (for themselves or their children)
- Buy a car
- Make a down payment to buy a vacation home
- Consolidate other debts, such as credit card debt
- Pay bills during a financial crisis, such as a job loss, if they don’t have an emergency fund
One particularly bad reason for taking out a HELOC is to get more cash for your day-to-day needs. If you have to borrow money to make ends meet, that’s a clear sign that the way you’re living isn’t sustainable. Unless you do something to fix the problem, you won’t be able to pay off the loan when it comes due. Instead of borrowing, you need to look for ways to balance your budget – either by stretching your paycheck or by bringing in extra income.
How Much You Can Borrow
The maximum amount you can borrow with a HELOC depends on how much equity you have in your home. That, in turn, depends on two things: how much your home is worth, and how much you still owe on the mortgage. Typically, the credit limit on a HELOC is 75% to 85% of your home value, minus your mortgage balance.
For example, suppose you have a house that’s worth $400,000, and you have $275,000 left on your mortgage. Your bank offers you a HELOC based on 80% of the house’s value, or $320,000. Subtract the $275,000 you owe, and that gives you a maximum limit of $45,000 on your line of credit.
However, the bank might not be willing to lend you this much. Before setting your credit limit, it will want to be sure that you can afford to pay back the loan. To figure this out, the bank looks at your income, your credit rating, and your other debts and financial obligations. This gives the bank a clearer idea of how much you can afford to borrow.
With many HELOCs, you can borrow as much or as little as you want, up to your credit limit. However, some loans require you to borrow a certain minimum amount, such as $300, every time you draw on your credit line. Others require you to take an initial advance as soon as you set up the HELOC.
A few HELOCs even require you to keep a certain amount outstanding at all times. That’s bad news for you, because it allows the bank to charge you interest all the time. It’s like having a credit card that you’re not allowed to pay off. You’re required to carry that $300 balance, and pay interest on it, month after month – whether you need it or not.
Interest Rates for HELOCs
Most HELOCs are variable-interest loans, also known as adjustable-rate loans. That means the interest rate is tied to an index, such as the U.S. Prime Rate set by the Federal Reserve, and it goes up and down along with that index. In most cases, the bank charges you the amount of the index plus a “margin,” such as two percentage points. For a HELOC based on the Prime Rate, this would give you an interest rate of “Prime plus 2%.”
The danger of an adjustable-rate loan is that as interest rates rise, so do your payments. If the current Prime Rate is 4%, a HELOC with a rate of Prime plus 2% would have a total APR of 6%. If you borrow $10,000 today at that rate, you’ll pay $50 a month in interest. However, if the Prime Rate shoots up to 10%, your interest rate rises to 12%, and your interest payments jump to $100 per month.
Fortunately, there’s a limit on how high the interest rate on your HELOC can go. By law, any variable-rate loan that’s secured by a home must have a ceiling, or cap, on how much the interest can rise over the life of the loan. For instance, if your HELOC is capped at 16%, then your interest rate can never go above that – even if the Prime Rate rises to 15% or more. Some plans also have periodic caps, which limit the amount the interest rate can rise in a certain time frame.
Sometimes, a HELOC has a special introductory rate. For example, the bank could charge you a flat interest rate of 2.5% APR for the first six months. After that, the interest rate would jump to the standard rate.
Other Fees for HELOCs
When you set up a HELOC, you usually have to pay many of the same fees that you paid when you first got your mortgage. For instance, you could be charged for:
- An application fee, which isn’t always refunded if you’re turned down for the loan
- A property appraisal to estimate the value of the home
- Upfront charges, such as “points,” where one point equals 1% of your credit limit
- Closing costs, such as a title search and attorney’s fees
All told, it can cost you hundreds of dollars to set up a new HELOC. On top of this, some HELOCs have ongoing fees that last throughout the life of the loan. For instance, you might pay an annual fee to maintain the loan or a transaction fee every time you draw on your credit line.
Benefits of a HELOC
A HELOC has several advantages over other ways to borrow money. These include:
- Flexibility. A HELOC lets you choose exactly how much you borrow and when. You can take out money and pay it back freely throughout the draw period. And once the draw period ends, you usually have a long repayment period to pay off the loan.
- Low Interest. A HELOC is less risky for the lender than many other loans, because it has your home as collateral. For this reason, banks tend to offer lower interest rates on HELOCs than on other types of credit. This makes a HELOC a useful way to consolidate higher-interest debts, such as credit card debt. However, this is only helpful if you refrain from using the credit cards while you’re paying off the debt. If you turn around and run the balance right back up, you’ll just have new debt on top of old.
- Right to Pay Early. No matter what the minimum payment is on your HELOC, you can always choose to pay more. In fact, many consumers choose to treat their HELOC just like any other loan and pay it off in installments. For instance, say you take out $20,000 from your HELOC and use it to buy a boat. You could then break up that $20,000 into 60 payments, add interest, and pay it back over five years. That way, it’s just like having a regular boat loan, but at a better interest rate.
- No Payment When There’s No Balance. Just like a credit card, a HELOC can be paid off in full at any time. If you do that, you don’t have to make any payments until you draw on it again. Of course, this feature doesn’t help you if your HELOC requires you to carry a minimum balance.
- Tax Deductions. Because a HELOC is a type of home loan, the interest on it is usually tax-deductible. That’s a perk that most forms of credit, such as credit cards and auto loans, don’t have.
- A Chance to Change Your Mind. When you take out a HELOC on your primary home, you have a legal right to cancel it within three days and pay nothing. You can change your mind for any reason, or for no reason at all. All you have to do is inform the lender in writing, and it must cancel the loan and pay back any fees you’ve paid. So, if you get a better offer from another lender – or if you decide you don’t need the money – you have a chance to back out.
Drawbacks of a HELOC
Although a HELOC can be a handy way to borrow money, it’s not the best choice for everyone. HELOCs have some serious drawbacks, including:
- Risk of Foreclosure. The biggest problem with a HELOC is that you’re putting your house on the line. If you’re ever unable to make the payments – either because your income goes down or because the payments go up – the bank could seize your home. If your income is unstable, a HELOC is probably too risky for you.
- Risk of Being Underwater. If your home drops in value while you still owe money on it, you could end up owing more than the house is worth. That’s a risky situation to be in, because if you sell your house, you have to pay the full balance on your HELOC immediately. If you need to sell unexpectedly, you could be caught short without enough cash to pay it back.
- Risk of Having Your Credit Frozen. If the bank sees that your house has dropped in value, or your income has dropped so low that you might have trouble making payments, it can decide to freeze your credit line. You can’t be kicked out of your house in this situation, but you also can’t draw on your credit. This is a big problem if you’re in the middle of a kitchen remodel and the bank suddenly cuts off your access to the money you’re using to pay the contractors.
- Uncertain Rates. Because most HELOCs are variable-rate loans, the monthly payment on them can jump – sometimes sharply. This can be a problem if you’re on a tight budget. Before signing up for a HELOC, check on what the lifetime cap is, and figure out what your monthly payment would be at this maximum rate. If that payment is more than you can handle, this loan isn’t a good choice for you.
- High Upfront Costs. As noted above, taking out a HELOC can cost you hundreds of dollars in fees. This makes it a poor choice if you only need to borrow a small sum of money. The amount you save on interest in that case is unlikely to be enough to offset the upfront costs. For this kind of loan, you’re better off with a low-interest credit card – or better yet, one with an interest-free introductory period. However, banks are sometimes willing to waive some or all of the closing costs on a HELOC, so check the terms before you rule out this type of loan as an option.
- Big Final Payment. Whenever your HELOC expires, you have to pay whatever you still owe on the loan, all at once. If you can’t afford this “balloon payment,” you can lose your home.
- Restrictions on Renting. Under the terms of some HELOCs, you aren’t allowed to rent out your home while you owe money on it. In this case, if you need to move, you’ll have no choice but to sell the house – and pay the full balance on your HELOC at once. This makes a HELOC a poor choice if you think you might need to move anytime soon.
Alternatives to HELOCs
If you keep a lot of your wealth tied up in your home, a HELOC is a useful way to turn that equity into cash. However, it’s not the only way. There are at least two other types of loans that let you extract cash from your home: home equity loans and cash-out refinancing. Depending on your situation, one of these options could be more useful for you than a HELOC.
Home Equity Loans
A traditional home equity loan is a much simpler loan than a HELOC. You borrow a fixed amount of money upfront, and you pay it back over a fixed period. Also, unlike HELOCs, home equity loans usually have a fixed rate of interest. This means that your payments stay the same from month to month, so there are no surprises.
Home equity loans have other perks as well. For one, the interest you pay on a home equity loan is usually tax-deductible, as it is for a HELOC. In addition, you usually don’t have to pay any closing costs on this type of loan. However, you might have to pay other fees, such as an application fee or appraisal fee.
If you compare interest rates for HELOCs and home equity loans, you’ll probably notice that HELOCs tend to have a slightly higher APR. However, this doesn’t necessarily mean that a home equity loan is cheaper because the APR on the two types of loans is calculated differently. The APR for a HELOC is based solely on the indexed interest rate (for instance, the Prime Rate). With a home equity loan, by contrast, the APR factors in the interest rate, points, and other finance charges.
Another difference between a HELOC and a home equity loan is that with a HELOC, you can often make interest-only payments – even after the draw period. With a home equity loan, by contrast, you pay back both principal and interest over time. This makes the monthly payments somewhat higher. On the plus side, it means you don’t get hit with a balloon payment at the end of the loan term.
Because a home equity loan gives you a lump sum, it can be useful for big, one-time projects, such as a home remodel. However, taking out a large sum all at once also increases the risk of ending up underwater on your loan. When you draw out smaller sums from a HELOC, there’s less chance that you’ll borrow more than your home is worth.
Another way to tap the equity in your home is cash-out refinancing. This means refinancing your home for more than the amount you owe and taking the extra money in cash.
Normally, when you refinance your home mortgage, you simply replace your old loan with a new loan for the same amount, but at a lower interest rate. For instance, say you have a $200,000 mortgage at 6% APR, and you’ve already paid off $50,000 of that loan. Since you got that loan, interest rates have fallen, and now mortgage rates are around 4.5% APR. So, you pay off your old loan and take out a new one for $150,000 at 4.5%, lowering your monthly payment.
But suppose that in addition to lowering your interest rate, you’d like to borrow an extra $30,000 to remodel your kitchen. In that case, you can do a cash-out refinance. Instead of taking out a new loan for the $150,000 you owe, you take out one for $180,000. This will give you a higher monthly payment than a straight refinance, but it will still be less than what you were paying with your old loan.
A cash-out refinance often, though not always, offers lower interest rates than a home equity loan or HELOC. One drawback is that you have to pay closing costs when you refinance your mortgage. This can add hundreds or even thousands of dollars to your loan.
Cash-out refinancing is a good option when there’s a problem with your old mortgage, such as:
- High Interest Rate. If interest rates have fallen by 1% or more since you got your mortgage, refinancing is usually a good deal. With a cash-out refinance, you can lower your monthly payments and get cash up front at the same time.
- Uncertain Interest Rate. If you currently have an adjustable-rate mortgage, you’re at risk of seeing your monthly payments shoot up if interest rates rise. Refinancing to a new, fixed-rate mortgage lets you lock in low rates for the life of the loan.
- Too Long a Term. Refinancing can also help you pay off your mortgage early. If you have a 30-year mortgage, but you’ve already paid off a lot of the balance, you can refinance the lower balance over a shorter term, such as 15 years. Switching to a shorter term can usually get you an even lower interest rate, as well as help you get out of debt faster.
Getting the Best Deal
If you decide a HELOC is the right kind of loan for you, do some shopping around to find a deal that fits your needs. Check your primary bank first, since some banks offer discounts on HELOCs for their regular customers. Get a detailed quote there that includes information about interest rates, caps, and fees. Then check other lenders to see how their offers compare.
Here are a few points to keep in mind as you shop:
- Check the Interest Rate. Shopping for interest rates on a HELOC is a bit complicated. Since the interest rate is usually variable, you can’t look at one number and compare it across lenders. You have to ask each bank exactly what index its interest rate is based on – for example, the Prime Rate or a U.S. Treasury Bill rate – and what the margin is. Once you know the index, do a little research to find out how much that index tends to change over time and how high it has been in the past. That will give you a clearer idea how much interest you’re likely to pay over the life of your loan.
- Compare Caps. It’s also important to know what the cap on your interest rate is. That will tell you how high the monthly payment on your loan can possibly go if interest rates rise. Check both the lifetime cap on the loan and the periodic cap, if there is one. Make sure that you know, and can afford, the maximum possible payment.
- Compare Fees. Along with comparing the APRs between different banks, you’ll also need to get details about closing costs and other fees. These charges aren’t reflected in the APR for a HELOC. Make sure you can afford the upfront costs on any HELOC you’re considering, as well as the monthly payments.
- Watch Out for Introductory Offers. Some banks try to lure you in with a low introductory rate. However, this temptingly low rate only lasts for a short time, such as six months. If your bank offers you an introductory rate, find out when that rate expires, and what happens to your payments when it does.
- Understand How Payments Work. Find out whether the monthly payments on your HELOC will include both principal and interest, or interest only. Interest-only payments sound like a good deal, but when the plan ends, you’ll have to pay off the entire principal in a huge balloon payment. Even if your payments include both principal and interest, check to see if the portion that goes toward the principal will be enough to pay off the full balance by the time the loan expires. If it’s not, you’ll still end up with a balloon payment. In some cases, it’s possible to extend your loan or refinance the balloon payment if you have to. Find out about these options ahead of time.
- Check on Penalties. Ask lenders what the penalties are for making loan payments late. Also, find out under what conditions the lender would consider your loan to be in default. If that ever happens, the lender can demand immediate payment in full – and if you can’t make that payment, it can take your home.
- Read the Fine Print. Ask each lender whether the HELOC has any special rules, such as a minimum withdrawal amount or restrictions on renting out your home. Find out whether the HELOC requires you to carry a balance at all times throughout the life of the loan. If it does, you can probably do better somewhere else.
- Know Your Rights. Under the federal Truth in Lending Act, lenders must disclose all important details about a HELOC, including the APR, fees, and payment terms. The lender is not allowed to charge you any fees until it has given you this information. Moreover, if it changes any of these terms before you sign the contract, you have the right to walk away, and the lender must refund any fees you have already paid. And even after you’ve signed it, you still have the right to change your mind and cancel within three days.
In some cases, taking out a HELOC can be a wise financial move. It’s a cheap way to borrow money for projects that will increase your wealth in the long term, such as improving your home or funding your education. However, this cheap credit comes with one big downside: It puts your home at risk. That makes it extra important to be sure you can afford the costs – both up front and long term.
Before you take out a HELOC, check out all your options. Do the math to figure out whether a home equity loan or a cash-out refinance might be a better choice. Compare rates from lots of lenders to make sure you’re getting the best possible deal. And if you’re not 100% sure you can make the payments, don’t be afraid to walk away.
Have you ever used a HELOC? Would you recommend it to others?