Even with the array of financing options available today, homeowners have a unique advantage.
After building enough equity in your home, you might be able to borrow against that amount through a home equity line of credit, or HELOC. Because HELOCs are secured by an asset (your home), they are one of the most popular ways to borrow at lower interest rates — especially when you’re facing high costs for needs like home improvements, college tuition, or debt consolidation.
HELOCs are generally easy to get if you have at least 15% to 20% equity already in your home, and may offer certain benefits — like lower interest rates or longer loan terms — over other forms of financing such as personal loans and credit cards. A type of revolving credit line, a HELOC also may offer interest-only payments. And unlike an installment loan, borrowers can access their HELOC again and again as they pay down the balance (much like a credit card).
But before taking out what’s often referred to colloquially as a “second mortgage,” you’ll want to consider exactly how you plan to use a HELOC, plus look at a few alternatives that won’t put your home on the line.
In this article, we’ll share six ideas for what a HELOC can be used for. Plus, we’ll provide three alternatives if you decide that a HELOC isn’t right for you.
Is a Home Equity Line of Credit a Good Idea for Me?
HELOCs can give homeowners much-needed and flexible access to credit on an ongoing, revolving basis, if they can meet the requirements. Once established, these lines of credit can serve as a helpful backup reservoir of funding for projects that exceed your everyday budget.
That said, HELOCs have fees and conditions that every borrower should be aware of. Depending on the size of your HELOC, you might encounter closing costs to apply for and use your line of credit. These fees may include costs for originating, underwriting, closing, and recording your loan. Additionally, some HELOCs have initial restriction periods, lasting from a couple months to a few years, during which time you could be charged a prepayment penalty or early termination fee for paying off the loan or closing the credit line. Different lenders may charge different fees, and some may even waive certain fees altogether, so be sure to ask your lender exactly what you’ll be paying.
Be sure to shop around multiple lenders to make sure you’re getting the best deal. Don’t just look at rates, either; make sure you also look at fees and the total cost of borrowing.
Banks commonly advertise “no-fee” HELOCs which require no cash to open and come without prepayment penalties. Your bank may offer targeted discounts based on your existing relationship and account balances. Plus, some lenders offer introductory pricing that brings the rate even lower for the first few months that your HELOC is open. Research thoroughly before applying — and remember that even a “no-fee” HELOC will at least charge interest.
Pros and Cons of a HELOC
Notably, HELOCs are known for offering interest-only payments, which make them an even more attractive option for flexible financing. However, every benefit comes with a caveat, according to Casey Fleming, a mortgage advisor for Fairway Independent Mortgage Company.
“Too many people just pay the minimum payment on their HELOC,” says Fleming. “They end up paying for that shopping spree for the next 25 years. Only go this route if you have a plan to pay off the balance quickly,” he says.
Here are some additional pros and cons of taking out a HELOC:
May offer interest-only payments for the first year(s)
May allow borrowers to access revolving credit worth up to a certain percentage of their home’s value (typically 85%)
Interest may be tax deductible if the funds are used to improve the value of your home
Can be used however you want
Interest-only payments require extra discipline, and might encourage spending beyond your means
Could charge closing costs, like on a primary mortgage (but not always)
You usually need at least 15% to 20% equity in your home to qualify
Failure to pay back could result in foreclosure on your home
5 Common Uses for a HELOC
You don’t have to use a HELOC for home-related expenses only.
If you’re wondering what else you can use a HELOC for, here are some options:
HELOCs are “especially good for home improvement projects when you don’t know what the final cost will be,” says Michelle Lambright Black, a credit expert and personal finance writer. Construction projects are notorious for going over budget or changing scope midway, and you don’t want to run out of money before your project is complete.
According to Lambright Black, a “hidden benefit” of using a HELOC to pay off credit card debt is that it can improve your credit score. Credit bureaus don’t factor HELOC utilization into credit scoring, so moving credit card debt to a HELOC could lower your reported credit utilization ratio. Such a boost to your score could help you qualify for better rates and terms on other loans.
Purchasing another property
If you want to buy a vacation home or rental property, a HELOC can simplify the process. Assuming the equity in your home is comparable to the cost of another one, using HELOCs as opposed to a traditional mortgage could help you avoid the typical 30- to 60-day underwriting process.
Assuming you could afford to “cash out” your HELOC, your offer on a new home might be considered stronger than competing buyers because it would not be contingent on bank financing.
A back-up emergency fund
The general rule of thumb is that you should have an emergency fund that covers three-to-six months of expenses. While that is ideal, the reality is that most families do not have that much set aside for emergencies. A HELOC can serve as a backup to your emergency fund in case something unexpected arises.
Cover business expenses
Business owners can often use a HELOC with lower rates than what’s charged on a small business loan. Plus, a HELOC doesn’t require that your business be open for two years before getting approved, as most small business loans do.The HELOC can be used to start a new business, cover ongoing expenses, or expand an existing business. But be aware of the risks associated with investing in a business using your home as collateral.
Alternatives to a Home Equity Line of Credit (HELOC)
If you need funding but don’t think a HELOC may be the best option for you, here are a few alternative ways to get the financing you need:
With interest rates near historic lows, doing a cash-out refinance on your existing mortgage can lock in low rates for the next 15 to 30 years. According to Fleming, a cash-out refinance “is a good idea if your current mortgage doesn’t have a low interest rate.” And, since a traditional mortgage payment includes both principal and interest, your balance is being reduced with every payment. In comparison, payments on an interest-only HELOC during the draw period would not reduce your principal balance.
Credit card 0% APR promotion
Many credit cards offer an interest-free promotion period when you first open the account. These 0% APR promotions can be used for purchases, balance transfers, or sometimes both. Some of these promotions can last up to 18 months or longer. While some banks charge a balance transfer fee of 3% to 5%, they typically don’t charge a fee on purchase promotions.
“These offers are a good idea if you can pay off the balance before the promotion expires,” says Lambright Black.
Personal loan or line of credit
While personal loans or personal lines of credit may have a higher interest rate, they generally can be opened very quickly. In some cases, borrowers can see cash in the bank account on the same day as their application.
Meanwhile, most HELOCs require an appraisal, and underwriting can take a few weeks before the application is approved. Not to mention, HELOCs sometimes require that you keep the credit line open for a minimum of a couple years. Therefore, if you need quick cash for a specific purpose (and plan to pay it back quickly), personal loans can be preferable in this scenario.