Your home is not only your most valuable asset, it’s also an investment tool you can use for your benefit. As your home builds equity, a HELOC, or home equity line of credit, can allow you to tap into that equity and gain access to cash for various financial needs. It’s important to understand how a HELOC works, the best ways to use the funds, and things to avoid. With this knowledge, you can determine if tapping into your home equity is the right move for you.
- A HELOC is a home equity line of credit that uses your home as collateral.
- Qualifying for a HELOC requires a good credit score and substantial home equity.
- There are no stipulations on how you can use the money from a HELOC.
- Since a HELOC secures your home as collateral, you could put your home at risk if you default on repayment.
How a HELOC Works
A HELOC, or home equity line of credit, is a type of loan that works like a revolving line of credit. It allows you to borrow money against the equity in your home by using your home as collateral. Typically, a HELOC loan offers you access to up to 80% of your home’s equity. All HELOCs have a credit limit, and most often start with a variable interest rate.
Your home’s equity is the amount your home is worth (current market value) minus the amount you still owe on it.
Suppose your home is appraised at a $200,000 value, but you still owe $80,000 on the mortgage. In that case, you have $120,000 worth of home equity. You can apply for a HELOC up to 80% of the equity; in this case, that would give you access to $96,000.
Unlike other loans, with a HELOC, you can withdraw money as needed during the draw period, which usually spans about 10 years. During that time, you can make monthly payments to replenish the credit line and continue to reuse it, similar to a credit card. You’ll make interest-only payments only on the amount you use during the draw period.
Once the draw period ends, you must repay the loan in full over the next 10 to 20 years, depending on how long your repayment period lasts. Since you’ll most likely have a variable interest rate, your payments can go up or down over time. Many people choose to refinance their HELOC into a traditional loan with fixed monthly payments.
5 Things You Can Do With a HELOC
HELOCs are appealing because you can withdraw as much money as you need when you need it, and you only have to pay back what you borrow. In addition, there are no stipulations on the money. As long as you have enough equity in your home and meet the lender’s requirements to qualify, you can use the funds for anything you choose.
However, even though you can use a HELOC for anything, should you? Since you’re securing the loan using your home as collateral, it’s important to consider that there are some good ways to use a HELOC—and some not-so-good ways.
Fund Home Renovations
One of the most common ways of using a HELOC is putting the money back into your home. For example, making home improvements such as updating the kitchen, adding another bathroom, or retiling the floors can increase the overall value of your home. Additionally, a HELOC is a great fit if you plan to complete home improvements in stages, because you can withdraw money as you need it.
Interest paid on a HELOC may be tax-deductible when the funds are used to “buy, build, or substantially improve the taxpayer’s home that secures the loan,” according to the Tax Cuts and Jobs Act (TCJA) of 2017.
Pay Off Expensive Debt
Another good way to use a HELOC is to eliminate debt, especially for those with high credit card balances and high interest rates. The caveat to doing this is that you are converting unsecured debt (credit cards) into secured debt (using your home as collateral). If you can’t make your credit card payments, the worst thing that will likely happen is you’ll take a hit to your credit report. On the other hand, if after using the HELOC to pay off those credit cards, you can’t make the HELOC payments, you’re putting your home at risk.
When applying for a HELOC, lenders will assess several factors, including your home value and equity, debt-to-income ratio, loan-to-value ratio, and your credit score.
Start a Business
Tapping into a HELOC to start a business can be a double-edged sword. The reason is because you may come across a great business opportunity or have your own great idea, but don’t have the funds to make it happen. Using a HELOC to finance your venture may offer you the flexibility and financial security to get your business off the ground. On the flip side, you’re using your home as collateral for a business idea that may or may not succeed. You may wish to explore other financing options such as business loans, investments from family and friends, or crowdfunding.
Make Major Purchases
Some people may feel there are situations where using a HELOC to pay for major purchases such as a dream wedding or a once-in-a-lifetime vacation may make sense.This may be a tempting option since HELOCs often offer more flexibility and lower interest rates than borrowing on a credit card or taking out a personal loan. However, many experts believe that using your home equity for extravagant expenses may not be the best strategy.
Manage Financial Emergencies
Financial emergencies can happen out of the blue; for instance, losing a job, a medical emergency, or getting hit with an expensive car repair bill. If you don’t have an emergency fund in place, a HELOC may come in handy to help you meet those financial needs until you get back on your feet.
When a HELOC Is a Bad Idea
In addition to putting your home at risk, a HELOC can also eat away at the precious equity you’ve built up in your home. To protect your home’s equity, there are some situations where you want to avoid tapping into a HELOC until you’ve considered all other options.
One example is paying for college. If your child doesn’t have a college fund, a HELOC can seem like an alternative solution. However, federal student loans typically have better interest rates and offer additional benefits, such as forbearance and forgiveness opportunities.
Buying a car is another place where you should avoid using a HELOC. If you stop making car payments, you can lose the car without losing your home in the process. Investing in real estate or stocks is another area to avoid, especially since investments are risky and returns are not guaranteed.
Before using your HELOC to pay off debt, make sure your debt payoff plan is well thought out and solid. Many HELOCs come with variable interest rates that change over time. This means your payments may not be the same every month.
The Bottom Line
Although HELOCs may provide more flexibility with access to cash and lower interest rates than other lending options, you’re putting your home up as collateral—so you should make your spending decisions wisely. First, consider if you can eventually afford to handle two payments: your regular mortgage and the new HELOC. Then decide if the risk is worth it, or if other financing alternatives may better fit your financial needs.
Frequently Asked Questions (FAQs)
How do I apply for a HELOC?
Applying for a HELOC is simple. Generally, you’ll need to provide the lender with the following:
- Personal information, such as two forms of government-issued identification
- Employment and income information (W2s, pay stubs, etc.)
- Mortgage details such as your most recent mortgage statement
- Property information (i.e., your address and appraisal value)
- Outstanding debts (student loans, auto loans, credit cards, etc.)
How much equity do I need for a HELOC?
How much money you can qualify for with a HELOC is primarily based on the amount of equity you have in your home. Depending on your mortgage lender, you can typically apply for a HELOC once you have accumulated at least 15%-20% equity in your home.
How does HELOC repayment work?
Once you begin making withdrawals from your HELOC, you will make interest-only monthly payments on the amount you borrow during the draw period. You may also be charged an annual fee for keeping the line available. After the draw period ends, the principal and interest will combine. You’ll begin repaying the balance in monthly payments over a 10- to 20-year timespan, depending on your loan terms.
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