Does a Home Equity Line of Credit (HELOC) Make Sense for You?

Pronounce it “He-Lock” if you’re in the Know

Home on a Pile of Cash
If you've got equity in your home, either leave it alone or use it wisely. John Lund/Blend Images/Getty Images

A home equity line of credit, or HELOC, is where you borrow using equity in your home as collateral. 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. It’s similar to a credit card in that you withdraw money as you need it.

But don’t confuse a home equity line of credit with a home equity loan. A home equity loan is where the 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—you can use the money, pay it off and use it again. A home equity loan also comes with a fixed interest rate whereas a HELOC is variable.

Requirements of a HELOC

One of the main requirements for qualifying for a home equity line of credit is, of course, having equity in the home. Banks require you maintain 10 to 20 percent equity in the home at all times, even after you take out a home equity line of credit. In order to qualify, borrowers must have substantial equity in their home. Other requirements of a HELOC include proof of income, steady employment and a good credit score (typically above 680).

An example of a HELOC

Let’s say you purchased your home for $210,000 and have paid off $100,000. For simplicity sake, the house is still worth $210,000, leaving you with $100,000 in equity. Assuming the bank requires you to maintain a 20 percent loan-to-value ratio, you could get a HELOC for $100,000 minus $42,000 ($210,000 x 20 percent = $42,000) which is $58,000.

Is a HELOC right for you?

First and foremost, you need to decide what you want to do with the money. If you’re looking to do home renovations, a common reason for getting a HELOC, a home equity loan might possibly be a better fit. A loan would give you one lump sum allowing you to complete your renovations and pay back the loan.

A line of credit allows you to repeatedly pay back and borrow, just like a credit card. Though the interest is typically much lower than on a credit card, it could still be dangerous if you’re constantly borrowing and repaying. In other words, you don’t want to get in over your head.

On the other hand, a HELOC might be your best bet if you are paying for a child’s college tuition. Tuition is a revolving bill, which is a scenario where a HELOC makes sense. Pay the tuition, pay off the amount, and then repeat next semester.

If you’re looking to consolidate debt by paying off high-interest credit cards, a home equity loan might be a good choice since the monthly payments are fixed. Get the money, pay off the cards immediately and start making your payments to the bank at a lower rate. While a HELOC can do the same thing, as you pay off the HELOC the money becomes available again. For some, this money is tempting and can put them back in debt, exactly where they started.

For some borrowers, tax benefits make HELOCs and home equity loans even more affordable – the interest you pay on these loans might be tax-deductible. Speak with a tax preparer to find out what the requirements are and how to take any deductions.

You might need to itemize, and there are limits (including, among others, limiting interest charges to debt up to $100,000). Details are available in IRS Publication 936.

Questions to ask before getting a HELOC include:

  • What do you need the money for?
  • Can you save up for it instead of relying on a loan?
  • Can you afford the worst-case-scenario payment, or the one at the highest interest rate possible?
  • 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 your home is being used 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. You might also have problems selling your home due to an additional lien being placed on the property.

Ultimately, only you can decide if a HELOC is right for you. Make sure to fully understand the fees, terms and conditions of the line of credit. It’s still a debt and should be taken seriously. If there’s an option available that doesn’t require a debt, such as picking up a part-time job to earn more money, it’s always best to go that route.

This article was edited by Justin Pritchard.