If you've got a home improvement project or a special vacation on the horizon, you can potentially use a home equity line of credit (HELOC) for funding. A HELOC allows you to borrow money by using your home's equity as collateral.
With a HELOC, your lender sets a borrowing limit, and you can choose to borrow as much of that as you want for an agreed-upon period of time. This approach is similar to a credit card or any other line of credit—you withdraw money as you need it, and you only pay for what you borrow.
Contrast that with a standard home equity loan, where a lender gives you one lump sum and you make the same payment every month until the loan is paid off. A line of credit differs in that it’s revolving, meaning you can use the money, pay it off, and borrow from the same pool of money repeatedly.
A home equity loan typically comes with a fixed interest rate, whereas a HELOC has a variable rate.
Requirements of a HELOC
One of the main requirements for qualifying for a HELOC is having enough equity in your home. Banks typically require that you maintain between 10% to 20% equity in your financed home at all times, even after you take out the HELOC. Other requirements of a HELOC might include proof of income, steady employment, and a good credit score.
A HELOC Example
Suppose you purchased your home for $210,000 and have paid off $100,000. For simplicity's sake, the house is still worth $210,000, leaving you with $100,000 in equity. Assuming the bank requires you to maintain a 20% loan-to-value ratio, you could potentially get a HELOC for $100,000 minus 20% of your home's total value of $210,000.
This works out to $42,000 (($210,000 x 20%) that the lender wants to you keep in the property. As a result, you might have $58,000 available for borrowing.
Is a Standard Loan Right for You?
First and foremost, be clear about what you want to do with the money. If you’re looking to do home renovations (a common reason for getting a HELOC) a standard home equity loan could be a better fit. Those loans provide one lump sum, allowing you to complete your renovations and pay the loan back in a straightforward manner.
A line of credit allows you to repeatedly pay down and re-borrow, just like a credit card. Though the interest rate is typically much lower than the rate on a credit card, it could still be a signal of financial trouble if you’re constantly borrowing and repaying. In other words, you don’t want to get in over your head.
If you’re looking to consolidate debt by paying off high-interest credit cards, a home equity loan with fixed monthly payments might be appropriate. Get the money, pay off the cards immediately, and start making your payments to the lender at a lower rate. While a HELOC can do the same thing, as you pay off the HELOC the money becomes available for borrowing again. For some, that temptation can result in going back into debt.
When a Line of Credit Makes Sense
On the other hand, a HELOC might be your best bet if you are paying for a child’s education expenses. Tuition is a revolving bill, making it a decent fit for a HELOC. You can pay tuition at the start of the semester, pay off the debt, and then repeat next semester.
For some borrowers, tax benefits make HELOCs and home equity loans are more affordable, as the interest you pay on these loans could be tax-deductible. Speak with a tax preparer to find out the requirements and how to take any deductions. You might need to itemize or use the funds in specific ways, and there are limits involved. Details are available in IRS Publication 936.
Ask your CPA about tax implications before you decide on a HELOC.
Questions to Ask Before Getting a HELOC
- What do you need the money for?
- Can you save up and pay cash instead of relying on a loan?
- Can you afford the worst-case-scenario payment or the one at a high interest rate?
- Will you be tempted to use the money carelessly?
- What is your plan to pay off the debt?
- What are the terms and interest rates?
Remember that you're pledging your home as collateral. If you fall on hard times for any reason, such as an unexpected job loss or medical expenses, you risk losing your home if you can't make payments on your loan.
Ultimately, only you can decide if a HELOC is right for you. Make sure you fully understand the fees, terms, and other features of your line of credit. Although the debt may be relatively inexpensive, it’s still a debt and must be taken seriously.
Consider options to achieve your goals without taking on additional debt. For example, it may be possible to delay spending, pick up a part-time job, or sell items to generate cash.