What to consider before getting a home equity line of credit (HELOC)

If you have a solid amount of equity in your home, a home equity line of credit (HELOC) can be a powerful tool for financing home improvement projects, consolidating debt, or just giving you access to extra cash in a pinch. HELOCs are flexible and tend to have low rates thanks to the security offered by using your home as collateral.

Despite their advantages, HELOCs do have some important drawbacks to consider, so it’s important to make sure you fully understand HELOCs and how they work before you apply for one

Key takeaways

• A home equity line of credit lets you turn your home equity into a flexible source of cash.
• HELOCs typically have lower rates than unsecured loans because you use your home as collateral.
• You can use the money from a HELOC for many purposes, including home improvement or consolidating debt.

What is a HELOC and how does it work?

A HELOC is a type of line of credit that relies on the value of your home and the equity you’ve built to act as collateral.

When you apply for a HELOC, your lender will look at the value of your home and the amount of equity you have in it. In other words, how much your home is worth minus the amount of your mortgage and any other loans secured by the property.

If you’re approved for the HELOC, you’ll receive a credit limit that is some amount less than your total home equity. You can then draw money from your HELOC when you need to, using it for whatever purpose you see fit. Typically, you only pay interest on the amount you borrow and can draw from the HELOC multiple times.

There are two key stages in the life of a HELOC:

• The draw period. This is the length of time that you can take money out of the HELOC. Usually, this period lasts about ten years. Most lenders only require that you pay accruing interest during this time.
• Repayment. Once the draw period ends, your HELOC enters repayment. During this time, you cannot take any more money out of the HELOC. Instead, you’ll pay the loan back with full principal and interest payments, usually over a period of ten to twenty years.

Consider this example.

You own a home worth $500,000 and owe $300,000 on the mortgage. You have $200,000 in equity in the property. Your lender might approve you for a HELOC with a limit of $120,000 and a draw period of ten years.

That means that over the next decade, you can take money out of your HELOC, up to a total of $120,000, whenever you need extra cash. You’ll only make payments based on the amount you’ve taken out. You can even make additional payments to reduce your HELOC’s balance, giving you more flexibility to make withdrawals in the future.

Once the draw period ends, you can’t make more withdrawals and will pay the balance of the HELOC off over a period of time outlined in your loan agreement.

Pros of a HELOC

There are a lot of benefits to HELOCs that can make them appealing to borrowers.

• Lower rates than unsecured loans: Your home serves as collateral for a HELOC, which makes it less risky for lenders. That means that HELOCs typically have lower interest rates, which makes them cheaper in the long run.
• Interest on a HELOC may be tax deductible: In some cases, the interest you pay on your HELOC can be deductible on your tax return. To qualify, you must use the proceeds from the HELOC to buy, build, or improve the home. Rules vary slightly depending on when you received the HELOC, so be sure to check with a tax professional.
• Repayment is flexible: During the draw period of a HELOC, you typically only have to pay interest as it accrues and can leave principal payments to the repayment period. However, you are free to make larger payments during the draw period if you want to pay down some of the balance.
• You can borrow multiple times during the draw period: You can draw money from your HELOC multiple times, on an as-needed basis. This makes a HELOC useful when you need quick access to cash, but the timing or amount you need can be unpredictable.

These advantages in practice

Imagine that you want to redo the kitchen and the bathroom in your home but don’t have the cash to pay for the remodel out of pocket. You can instead use a HELOC to finance the cost of the improvements.

Remodeling projects can be unpredictable and take some time, so a HELOC is a good fit for multiple reasons. You can apply for the HELOC at the start of the project and take some money out to get the ball rolling. As you need more cash to pay for the project, you can make additional withdrawals.

Another perk is that you’re not obligated to withdraw the full amount of the HELOC if you don’t need to, which can save you from overborrowing if the project comes in at a lower than expected cost.

Cons of a HELOC

HELOCs aren’t perfect for everyone, so it’s important to consider their drawbacks before applying.

• Your home becomes collateral: The reason HELOCs tend to have lower interest rates than other loans is that your home serves as collateral. That means that if you fail to make your required loan payments, the lender can foreclose on your home. In effect, a HELOC puts your home at risk if you find yourself unable to pay.
• The interest rate isn’t fixed: Many HELOCs have variable interest rates that rise or fall based on market conditions. If market rates rise, the interest rate of your HELOC will also increase. That will cause your monthly HELOC payment to increase, potentially to unaffordable levels.
• The equity in your home will decrease: Because your HELOC is secured by the value of your home, your HELOC balance reduces your home equity just like your mortgage balance does. This might not be an issue at all but can cause problems, especially if your home decreases in value. If you wind up with negative equity because of your HELOC, you could have trouble refinancing your mortgage or possibly even selling your home.

The disadvantages in practice

Imagine a scenario where you apply for a HELOC and draw money from it to help consolidate some of your credit card debt. This seems like a great deal because typical credit card rates exceed 20%, while HELOCs have interest rates under 10%.

Suddenly, you face a major illness that leaves you unable to work. Now, you’re struggling to pay your bills, including your HELOC payment. What’s worse, an interest rate increase causes your HELOC rate to rise, making your payments even harder to deal with.

Having the HELOC in that scenario could put you at risk of foreclosure.

Alternatives to a HELOC

If you’re in the market for a loan but aren’t sure a HELOC is right for you, there are other options out there. You might want to consider one of these alternatives.

How to determine if a HELOC is right for you

HELOCs are a good fit for a few situations. In general, the key features of a HELOC are the fact that (assuming you have sufficient equity) you can borrow large amounts, pay a low interest rate, and have the flexibility to make multiple withdrawals from the HELOC over its life.

In some cases, those features are very important. A home renovation project that could take months or years and has an uncertain budget would greatly benefit from a flexible, low-cost loan.

On the other hand, those features aren’t helpful or important. Paying a large one-time bill or consolidating debt doesn’t require flexibility to make multiple withdrawals, so an alternative like a home equity loan may be more appropriate.

To decide if a HELOC is right for you, ask yourself these questions.

• Do I have a large amount of equity in my home?
• Do I need to borrow a large amount, but an amount less than my home equity?
• Is having the flexibility to make multiple withdrawals from a HELOC helpful in my situation, or do I want all the money upfront?
• Can I handle the uncertainty of a variable interest rate?

If you answered yes to those questions, a HELOC is likely a good fit.

How to apply for a HELOC

Applying for a HELOC is like applying for any other loan, the first step is to find a few lenders that you can work with and compare offers from.

Look for lenders in your area and also look for options from larger, national lenders. There are many services that will help you find and compare HELOC providers.

When comparing, the things to look at are the interest rate the lender charges and the fees you’ll have to pay. Some lenders charge an annual fee to keep the HELOC open or an origination fee, so keep that cost in mind.

Once you’ve chosen a lender, you’ll need to follow that lender’s process for applying. Typically, that involves filling out some paperwork about yourself and your home, letting the lender appraise the home’s value, and waiting for approval.

The bottom line: A HELOC offers flexibility, but it isn’t for everyone

HELOCs are appealing because of their flexibility. A key feature is the ability to make multiple withdrawals on an as-needed basis, meaning you don’t need to borrow the full amount right away. If you’re in a situation where you need quick access to cash but a typical lump sum loan isn’t quite right, consider a HELOC.

While Rocket Mortgage® doesn’t offer home equity lines of credit, there are other ways we can help. Rocket Mortgage® offers multiple types of financing that may meet your needs.