HELOC Pros And Cons To Consider
February 15, 2024 7-minute read
Author: Dan Rafter
Need to fund a major kitchen remodel, cover the costs of a primary bathroom addition or pay off high-interest credit card debt? A home equity line of credit, better known as a HELOC, can help.
A HELOC is a bit like a credit card but with your home’s equity as your credit limit.
Like all home equity loans, they come with their own sets of pros and cons. Is a HELOC the right choice for you? That depends on what you need to fund and how comfortable you are with using your home as collateral.
At this time, Rocket Mortgage® does not offer HELOCs.
What Is A Home Equity Line Of Credit (HELOC)?
A home equity line of credit (HELOC) allows you to borrow against the equity you’ve built in your home. Unlike a home equity loan, though, a HELOC provides you with a credit line based on your equity.
Say you owe $200,000 on your mortgage and your home is worth $300,000. You have $100,000 of equity. Lenders won’t allow you to take out a HELOC for this full amount, but you might qualify for a home equity line of credit with a credit limit of $55,000. You can then borrow against this credit limit to pay for anything you’d like, including major home renovations, paying off high-interest credit debt or covering a child’s college tuition.
With a HELOC, you only pay back what you borrow. You might have a credit limit of $55,000. But if you only use your HELOC to pay for a $30,000 kitchen renovation and a $10,000 master bathroom upgrade, you’ll only need to pay back the $40,000 you’ve spent.
HELOCs feature two phases. The first is the draw period, when you can borrow money with your line of credit. This typically lasts 5 to 15 years. During this period, you'll only need to make payments that cover the interest on the amount that you have borrowed.
After the draw period ends, your HELOC enters the repayment period, which usually lasts from 10 to 20 years. During this period, you can no longer borrow money. Instead, you need to repay what you've borrowed. You'll do this by making monthly payments, with interest, that go toward paying down your principal balance.
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Pros And Cons Of HELOCs
As with all mortgage products, there are advantages and disadvantages with HELOCs.
HELOCs Can Have Lower Interest Rates
HELOCs typically come with lower interest rates than other forms of debt, such as credit cards and personal loans. However, your interest rate will depend largely on the market, your three-digit credit score and how much debt you face each month.
If you want the lowest possible interest rate with your HELOC, pay all your monthly bills on time and pay down as much of your credit card debt as you can. These two steps will help you build the strong credit score that lenders want.
The average interest rate on a HELOC is about 7% - 8% as of April 2023, according to Forbes. As of February 2023 – the most recent data – the average interest rate on credit cards was 20.09% and, for a 24-month personal loan, the average rate was 11.48%, according to the Federal Reserve Board.
The Interest May Be Tax-Deductible
A HELOC can also pay off come tax time. That’s because the interest you pay on a HELOC might be tax-deductible.
You can deduct the interest you pay on a HELOC if you’re borrowing money to build, buy or substantially improve your home. This requirement began in the 2018 tax year and is in effect through the 2025 tax year. You can’t deduct the interest, though, if you use your HELOC for other uses, such as paying off credit card debt or covering a child’s college tuition.
An example of improving your home would be adding a primary bathroom, renovating a kitchen or installing a second-floor addition. The combination of your HELOC and primary mortgage must also not exceed limits set by the IRS in order to take advantage of the full deduction.
Repayment Options Are Flexible
With a HELOC, you have flexibility when it comes to paying off what you borrow. You typically are required to only cover the interest on the amount that you've borrowed during your loan's draw period. But you can pay more, applying these extra dollars to paying down the principal balance of the amount that you've borrowed. You'll then have less to pay during your loan's repayment period because you’ll have already lowered the balance on what you owe.
You’re Able To Borrow Only What You Need
With a home equity loan, you borrow a set amount of money in one lump sum. With a HELOC, you instead get a line of credit that remains open during its draw period. You can then borrow what you need when you need it. Maybe you need to repair a leaking roof. You can borrow $15,000 to cover this repair. Then, maybe 2 years later, you’re ready to add a three-seasons room to your home. You can borrow $20,000 for this project at that time, so long as it’s within the draw period of the HELOC.
Your Home Is Collateral
A HELOC is an example of a secured loan, one that is backed by a form of collateral. In a HELOC, your home is your collateral. Make sure before taking out the loan that you can afford to make your payments on time, especially when your HELOC reaches its repayment period.
Your Interest Rate Can Change Over Time
Most HELOCs come with variable interest rates, meaning their interest rates can change throughout the life of your loan, rising or falling depending on the performance of whatever economic index they’re tied to. This can make budgeting for HELOC payments more challenging: Because the interest rate can vary, your monthly payment might rise or fall, too. Make sure before taking out a HELOC that you can afford your monthly payment even if it might rise.
Your Home Equity Decreases
The equity in your home will drop when you take out a HELOC. Say you owe $150,000 on your primary mortgage and your home is worth $300,000. You have $150,000 in equity. But if you take out a HELOC for $60,000, your equity will drop to $90,000, equal to $150,000 minus the $60,000 you took out as a HELOC.
You Might Overspend
Because a HELOC is an open line of credit, homeowners run the risk of overspending. Much like with a credit card, you can borrow as much as you’d like until you reach your credit limit. It can be easy to spend until you owe tens of thousands of dollars. That’s why it’s important to draft a plan for how you will spend your HELOC dollars.
Alternatives To A HELOC
A HELOC isn’t the only option you have when it comes to borrowing money:
- Home equity loan: Like a HELOC, a home equity loan is a type of loan that is based on the amount of equity you’ve built in your home. Unlike with a HELOC, you’ll receive your money in a single payment that you pay back monthly with interest. A home equity loan is a good choice if you already know exactly what you need money for and how much you need.
- Cash-out refinance: You might also choose a cash-out refinance. In this type of refinance, you borrow more than what you owe on your existing mortgage, receiving the leftover funds as a single payment. Say you owe $150,000 on your existing mortgage. You might refinance it for $200,000. You’d then receive that extra $50,000 as a single payment. You’ll pay back what you borrow with regular monthly payments with interest. As with a home equity loan, a cash-out refinance might be a good choice if you need a specific amount of money for a planned home-improvement project.
- Personal loan: With a personal loan, you’ll receive a single payment that you repay each month with interest. You can use the money from a personal loan for whatever you’d like. On the plus side, a personal loan is not backed by collateral. You can’t lose your home, or any other asset, if you stop making your payments. On the negative side, personal loans typically come with higher interest rates than do HELOCs. You might not be able to borrow as much, either.
Have questions about how HELOCs work? Here are the answers to some of the most common:
How do I know if a HELOC is right for me?
A HELOC can be a smart choice if you want the flexibility to borrow what you want when you need it. You can tap the funds from a HELOC whenever a costly repair pops up. You can also borrow money if you’re ready to take on a series of home-renovation projects.
What will happen to the equity in my home when I take out a HELOC?
You’ll reduce the equity you’ve built in your home when you take out a HELOC. That’s because equity is the difference between what you owe on all your mortgages and how much your home is worth. The addition of a HELOC will increase the amount you owe on your mortgages.
How do I obtain a HELOC?
You’ll work with a mortgage lender to take out a HELOC. This lender will check your credit score and review your credit reports. You’ll also have to verify your income by providing copies of such documents as your last two paycheck stubs, last 2 months of bank account statements, last 2 years of tax returns and last 2 years of W-2 forms.
How does a HELOC differ from a mortgage refinance?
When you refinance your mortgage, you replace your existing home loan with a new one. When you take out a HELOC, you keep your existing mortgage and add a line of credit to it, leaving you with two loans – and two payments.
The Bottom Line
Like all mortgage products, HELOCs come with their own set of pros and cons. Determining if a HELOC is right for you requires that you look at your financial situation and how you plan to spend the money from a home equity loan. Rocket Mortgage does not offer HELOCs. But we do offer home equity loans. If you’re interested in borrowing against your home’s equity, start an application today with Rocket Mortgage.
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