If you're a homeowner and you need to borrow money, you might not be aware of home equity lines of credit (HELOCs). They may not be as common as personal loans and credit cards, but HELOCs offer a number of advantages over other types of loans. For one, they're often cheaper, and you don't have to borrow the money until you need it.
HELOCs aren't for everyone, though. Learn more about whether a HELOC might be right for you, and if not, what other options you may wish to consider.
- A HELOC consists of two parts: the draw phase when you borrow money, and the repayment phase when you pay it back.
- A HELOC may be right for you if you're looking for affordable rates and would like the option to borrow money as needed over an extended period.
- A HELOC may not be right for you if you don't have equity in your home, or if you aren't able to prioritize repayment.
Is a HELOC a Good Idea for You?
HELOCs work a bit differently than most lending products you may be familiar with.
A HELOC is split up into two phases: a draw phase and a repayment phase. During the draw phase, you can borrow money and are only required to make interest-only payments. After a fixed time period, you'll enter the repayment phase, when you'll repay the money you borrowed either in full or over a specific time period.
This unique structure makes it better for some purposes than for others. Here are some questions to ask to determine if a HELOC is right for you or not.
Do You Have Enough Equity In Your Home?
In order to be approved for a HELOC, you'll need equity in your home. Many lenders will only allow you to borrow up to 85% of the home's appraised value, minus the amount you owe on your mortgage. If you've just bought the home and only have a small percentage of equity, you may not be able to get a HELOC.
Be sure to ask if there are any minimum or maximum withdrawal requirements, as well as how you may be able to spend money from your credit line—with checks, credit cards, or both.
Why Do You Need to Borrow Money?
There are many good reasons to use a HELOC, including:
- To cover education costs
- Repairing or improving your home
- Paying for treatment for a major illness
Each of these are large, single events that may require several smaller payments over a short period of time. For example, you might need to pay for several medical treatments, or several semesters, or for completion of certain renovation milestones. These expenses lend themselves well to HELOCs.
It's not a good reason, however, to use HELOCs to bridge constant cash-flow issues, such as if your income permanently dropped or your expenses permanently increased. This is just putting a short-term band-aid on something that needs a permanent solution.
Can You Prioritize Repayment?
Just about everyone who ever defaults on a loan doesn't necessarily plan on doing so. Nevertheless, sometimes things happen: You lose your job, a family member needs more care, or you're diagnosed with a chronic condition.
Either way, ask yourself whether you'll be able to prioritize repaying your HELOC even above all other debts (besides your mortgage, that is). If you default on a HELOC, it's possible you could lose your home.
What Are Your Other Options?
One of the reasons a home equity line of credit is a good option is because it is often much cheaper than the alternatives. A HELOC is secured by your home, and like other secured loans such as mortgages and auto loans, lenders often set lower rates. But if you can borrow the money you need elsewhere at a cheap rate without putting your house on the line, that might be a better option.
HELOC vs. Other Home Equity Options
When it comes to borrowing money, HELOCs aren't your only choice. Here are a couple of other types of loans that are similar, but may work better for you depending on your circumstances.
Home Equity Loan
Home equity loans are also secured against the equity you have in your home, similar to HELOCs. Unlike HELOCs that let you access money at will during the draw period and then repay it later, a home equity loan works much more like a traditional loan. You'll get one lump sum of money, and start repaying it immediately.
You might prefer a home equity loan if you need to borrow money for a true one-time expense, like replacing your roof or consolidating high-interest debt.
That way, you can restart the repayment process right away instead of making interest-only payments at first. Since interest-only payments can drive up your loan costs in the long run, a home equity loan may be a fitting alternative.
A cash-out refinance lets you refinance your mortgage loan into a new, larger mortgage. You get the difference back as cash that you can use however you wish.
You might prefer a cash-out refinance if again, you'll be making one large lump-sum payment with the money you’ve accessed. It can be especially advantageous if you can refinance your mortgage for a lower rate than your current one.
How To Get a HELOC
Getting a HELOC takes a little bit more work than most types of credit. It's a good idea to shop around for rates.
If you’re considering a variable rate, check and compare the term, as well as the periodic and lifetime caps, which determine the limit on interest rate changes at one time and throughout the loan term. Lenders will also use an index, like the prime rate, when noting how to raise or lower interest rates. Ask them which index is used, and how much and often those may change. Also check the margin, which is the amount added to the index, as well as if you have the option to convert your variable rate loan to a fixed rate some time down the road.
If you sign up for a HELOC with a discounted interest rate, be sure you understand how long your interest rate and payments will be lowered along with when the discount period ends and what your payments will look like at that time.
Be aware that it can take some time to be approved for a HELOC. The lender has to not only check your qualifications, it must also check your home's qualifications as well. This means they'll send out an appraiser to provide an independent assessment of your home's value.
If everything goes according to plan and you're approved for the loan, you can expect the process to take about 45 days from start to finish.
Frequently Asked Questions (FAQs)
Is it a good idea to get a HELOC when inflation is rising?
When inflation is rising, it often will make HELOC rates rise in tandem. And since HELOCs generally have variable interest rates, this means your loan could become more expensive. Your HELOC will have a periodic cap for how much it can increase at one time, and a lifetime cap for the highest it could be. These are good things to check when shopping around.
How much equity do you need for a HELOC?
Most lenders set the maximum credit limit on a HELOC by taking a percentage of your home’s appraised value (between 75-85%) minus what’s owed on the existing mortgage. That means you would need at least 15% to 25% equity in your home in order to qualify for a HELOC.
How does HELOC repayment work?
While you're in the draw phase, you'll only be required to make interest-only payments. You can pay more if you like, but it's not required. When you enter the repayment phase, you'll start making payments that are split up toward interest and principal, just like with a traditional loan.