The Pros and Cons of a Home Equity Line of Credit (HELOC)

A home equity line of credit, or HELOC, offers homeowners flexible access to a revolving source of funds on the equity they’ve built in their homes. 

HELOCs tend to have lower interest rates than other types of home loans. They can be a good option to finance a major expense like a home renovation, to consolidate debt or to cover an unexpected emergency. 

There are benefits to using a HELOC, particularly because you can borrow against your credit line at any time. But a notable downside is that you must put up your home as collateral to secure your loan, meaning you could lose your property if you’re unable to repay it. 

A HELOC may or may not make sense based on your personal financial situation. Here are the pros and cons of borrowing against your home’s equity with a HELOC.

What is a HELOC?

A HELOC is a home loan that allows you to tap into your home equity and access cash at a relatively low interest rate. HELOCs are revolving lines of credit that function similarly to credit cards, allowing you to withdraw money up to your total line of credit during your draw period (usually 10 years).

The most common uses of a HELOC are for home improvements, debt consolidation or other large expenses. However, as long as you have a clear purpose and repayment strategy, there’s no shortage of ways you can leverage your home equity.

In order to qualify for HELOC loan approval, you typically need to have:

• At least 15% to 20% equity built up in your home
• A good credit score (most lenders prefer a score of at least 700, but you can qualify with a score as low as 620 with some)
• Verifiable income
• A debt-to-income ratio that is 43% or less

Pros of a HELOC 

HELOCs tend to have lower interest rates than other types of loans because they’re secured by your home. They’re also popular for their flexibility -- you can take out money as needed over a 10-year period. HELOCs can be beneficial when you want money for a long-term project but aren’t sure of the exact amount you need. 

Low interest rates

HELOCs often have lower interest rates than other home loans, personal loans or credit cards. Securing the lowest interest rate possible will help save you tens of thousands of dollars over the lifetime of your loan.

Interest-only payments 

During your draw period, you can make interest-only payments on your HELOC, which means you won’t have to start paying back the principal loan balance until after the draw period ends. Plus, you don’t have to take all the money out at once. You pay interest only on the amount you’ve withdrawn and not the entirety of your loan, which helps you save significantly on interest.

Lengthy draw and repayment periods

Being able to continually take out money during a draw period of 10 years is a major advantage of a HELOC -- especially because you can make interest-only payments until your repayment period begins. That affords you flexibility in how you use your loan, and gives you time to plan ahead for when you have to start making payments on the principal balance plus interest.

Cons of a HELOC

The most obvious downside to a HELOC is that you need to use your home as collateral to secure your loan. In today’s rising interest environment, the fact that HELOCs have variable interest rates is also less advantageous, as the Federal Reserve has indicated that it will need to keep interest rates higher for longer.

Variable interest rates 

Unlike home equity loans or a cash-out refinance, which are fixed-interest rate loans, HELOC rates rise and fall depending on macroeconomic factors like inflation and job growth. HELOC rates were around 3% at the beginning of 2022 but have now surpassed the 9% mark. If you are concerned about rate volatility, a home equity loan may be a better option.

Your home is collateral for the loan 

The reason banks and lenders are able to offer you lower interest rates on your HELOC is because your home serves as collateral for the loan. That means it’s less of a risk for them because they can repossess your property if you default on your HELOC. However, most banks and lenders are usually willing to work with you to help you find ways to back your loan, as it also benefits them to keep receiving payments from you.

Higher payments during repayment period

While the cost of a HELOC is relatively low during the draw period, the repayment period can come as a shock -- especially in a rising rate environment. It’s important to consider how you will pay back both the interest and principal on your loan before you commit to borrowing with a HELOC.

Minimum withdrawals 

Although it will vary by lender and the specific terms of your loan, many lenders require you to make minimum withdrawals from your HELOC. That means you’ll have to pay interest on those funds even if you don’t end up using them, which will cost you more money in interest over time.

How to calculate your home equity

To calculate your home’s equity, start by identifying your home’s current value. Even if you purchased your house at a lower price years ago, your home equity is based on its present-day value. Most lenders will require an up-to-date home appraisal conducted by a professional to accurately determine your home’s current value. 

Popular sites such as Zillow or Redfin have home-price estimators you can use. They are not the most accurate, but they can give you a ballpark figure. 

Once you know your home’s current value, determine your outstanding mortgage balance and subtract it from the value. For this example, if your home is worth $400,000 and you have $200,000 left to pay on your mortgage, that means you have $200,000 of equity, or 50% equity, in your home. 

Your home equity will change over time based on the total amount of mortgage payments you’ve made as well as property value fluctuations. It’s a good idea to periodically reassess your home’s market value and mortgage balance to keep track of your home equity.