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How does a home equity line of credit work—and how can it help?
Considering borrowing money against your home's value? Here’s when it makes sense—and when it doesn’t
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Say you’re exploring ways to pay for a home renovation, cover an unexpected expense or streamline your finances. As you’re deliberating, keep in mind that a home equity line of credit (HELOC) could be a potential source of funding. A HELOC is a revolving line of credit based on your home’s equity—the difference between the home’s appraised value and the balance of your mortgage. With a HELOC, you can use your line of credit as needed throughout a borrowing or draw period, which is typically 10 years. During that time, you must make minimum monthly payments towards principal and interest. At the end of the draw period, you’ll have a set amount of time—usually 20 years—to pay off any remaining balance.
HELOCs come with both benefits and risks. They can provide you with funds at a lower interest rate than other kinds of loans, like credit cards and personal unsecured loans, and obtaining one can be quicker than going through a traditional loan process. On the other hand, you’re using your home as collateral. If you default on payments, the lender could foreclose on your home.
With these pros and cons in mind, here are five instances where a HELOC could make sense:
Upgrading your home
Making additions, repairs and renovations may help you keep pace as your housing needs evolve. Some home improvements—such as an increase in livable square footage, the renovation of an outdated kitchen or a new roof—could also increase the property's value.
Did you know?
The interest you pay on a HELOC may be tax-deductible if you use the money to buy, build or substantially improve your home. Energy-efficient upgrades could qualify you for additional rebates and tax credits. Check the IRS website or consult with a tax advisor for more details.
Borrowing at a lower interest rate
If you have substantial equity in your home, HELOCs may offer a lower interest rate than other types of credit, such as credit cards, car loans and private student loans. Additionally, banks often offer introductory rates and discounts on home equity lines of credit.
Interest rates on HELOCs may vary from month to month based on an underlying index. Some banks offer a fixed-rate option for some or all of your balance. On one hand, the fixed rate is often higher than the variable rate, but the benefit is that your monthly payments won’t change, making it easier to incorporate the debt into your budget.
Consolidating debt
If your HELOC’s interest rate is lower than rates on your other loans, including any credit card balances, you might consider simplifying your payments and reducing your interest costs through debt consolidation—paying off higher-interest-rate debt with a new lower-interest-rate loan. Just be careful not to run up new debt, such as on newly paid-off credit cards.
Quick tip
If you consolidate credit card debt using a home equity line of credit, you’re turning unsecured debt into secured debt, so you want to be confident you can afford the payments.
Paying for higher education
You can borrow money through your HELOC to make college tuition payments. Before making this choice, it's important to compare HELOC and student loan interest rates and repayment options. While lower interest rates are usually preferable, it's a good idea to talk to a financial advisor about the best option for your situation.
Quick tip
Expensive discretionary purchases, such as vacations or an extravagant wedding, are generally not the best reasons to draw on your home equity. Remember that the collateral for your HELOC is the place where you live, your home. Carefully consider all the options available to you.
Covering unexpected expenses
A home equity line of credit can help when you’re hit with unexpected expenses such as medical bills, recovery from a natural disaster, or a similar sudden cost. Ideally, you’ll have an emergency fund that you can tap first, but if you don’t, or it’s not enough, a HELOC can offer you access to needed cash.
