Homeowners have record-breaking equity right now, making a home equity line of credit, or HELOC, one of the best options for low-cost financing on the market.
The dramatic rise in home prices over the last couple of years is a big reason why. In the second quarter of 2022, nearly half of mortgaged residential properties were considered “equity-rich,” meaning mortgages and other home loans covered no more than half of their value, according to a recent report by ATTOM, a real estate data firm.
“In today’s current market, the labor market remains strong and homeowners are sitting on near record levels of equity,” says Odeta Kushi, deputy chief economist at First American Financial Corporation. “So even if you do lose your job, you still have the ability to sell your home, and not to the bank.”
Cash-out refinancing used to be the most popular way to turn that equity into cash, but higher mortgage rates have pushed those products out of the spotlight.
Enter the HELOC. A HELOC is a type of loan that is secured by your house and works much like a credit card. It lets you access a revolving line of credit you can continuously draw upon for virtually any purpose, from home improvements to debt consolidation. Its flexibility and relatively low interest rates compared to other debt products make it a popular option for homeowners needing funding, but it carries some risks and potential drawbacks as well.
Before you take out a HELOC, here’s what you need to know about the pros and cons.
Rates Are on the Rise
This week, the Federal Reserve announced a 50 basis point hike to the federal funds rate, a short-term interest rate that determines what banks charge each other to borrow money.
Inflation remains high, but November’s numbers offered a glimmer of hope that it’s starting to recede. The Consumer Price Index was up 7.1% year-over-year in November, lower than expected for the second consecutive month.
“This is certainly welcome news. But it’s difficult to say that it’ll be convincing for the Fed policy makers quite yet,” says Jeffrey Roach, chief economist at LPL Financial, a national broker-dealer. “It’s certainly going in the right direction, deceleration in price growth, but it’s still growing.”
On the heels of cooler inflation data, the Fed is slowing down the pace of its aggressive rate-hiking regime. That means a lot for consumers, especially those looking to borrow money.
HELOCs often have variable interest rates that are directly tied to an index- the prime rate- that moves in lockstep with the federal funds rate. When the Fed hikes rates, it becomes more expensive to borrow with a HELOC.
Home equity loans with fixed rates aren’t as directly affected, but those rates are set based on the lender’s cost of funds, which also rises as rates go up.
“Many economists expect rates to stabilize and, if we were to head into a recession, rates possibly could begin to slowly come down,” says Rob Cook, vice president of marketing, digital and analytics for Discover Home Loans. “Given all of the uncertainty, though, homeowners should generally expect rates to stay elevated in the near to mid-term.”
What Is a Home Equity Line of Credit (HELOC)?
A home equity line of credit (HELOC) is a line of credit secured by your home that you can use for anything. A HELOC works similar to a credit card in that you can continuously tap into the line of credit, up to the credit limit, during the draw period. You have access to the entire credit line and can spend as much or as little as you want, and you’ll only pay interest on the amount you spend. This makes it different from an installment loan — such as a home equity loan or personal loan — where you receive the full loan amount in a lump sum upfront.
HELOCs traditionally work on a 30-year model. You’ll have a 10-year draw period where you can draw money from your HELOC. Then you’ll have 20 years to pay off whatever you spent. However, other lengths of draw periods and repayment periods also exist.
If you have an interest-only HELOC, you’ll only be required to make payments that cover the interest, not the principal, during the draw period. You’ll begin full principal and interest payments during the repayment period. However, experts recommend making payments toward your principal during the draw period if you can, to avoid larger monthly payments during the repayment period.
Pros and Cons of a Home Equity Line of Credit (HELOC)
Lower interest rates compared to credit cards and personal loans
You may have the option to lock in, or fix, your rate
Only pay for what you spend
Use the money for anything
Some HELOCs come with special introductory interest rates or waived upfront costs
You can borrow more money than with a credit card or personal loan
Variable interest rates could increase in the future
There may be minimum withdrawal requirements
There is a set draw period
Possible fees and closing costs
You risk losing your house if you default
The application process for a HELOC is longer and more complicated than that of a personal loan or credit card
Comparatively lower interest rates
While the exact rate you’ll get depends on your credit score, a HELOC will typically have a lower interest rate than a credit card or personal loan. The average interest rate for a $30,000 HELOC is about 6.5% as of August 2022. Credit cards have an average APR of 15.13%, according to the Federal Reserve, while the current average rate for a personal loan is 8.73%.
HELOCs are variable-rate products, meaning that the rate will fluctuate over time, but even when HELOC rates rise they are still typically lower than most credit cards and personal loans.
Option to lock in your rate
Some lenders offer the option to lock in, or fix, your interest rate on your outstanding balance so you’re not exposed to rising interest rates after you’ve piled up a balance, says Greg McBride, chief financial analyst at Bankrate.
While this option isn’t always available and may come with certain fees or a higher initial interest rate, it can provide more stability to borrowers in a rising rate environment like the one we’re currently in.
Shop around with multiple lenders to find the best interest rate. Don’t forget to factor fees and other upfront costs into the calculation.
Only pay for what you spend
Like a credit card, you’ll only have to pay for what you spend on the HELOC, plus interest. This is different from other home equity financing options, like home equity loans, where you would have to take out and pay back the entire loan amount regardless of whether or not you used it.
This flexibility makes HELOCs good for projects where you don’t know the full cost at the onset. This way, the ability to tap into a large amount of funding is there if you need it, but you won’t be stuck paying interest on any money you don’t use, either.
Use the money for anything
Just like a credit card or a personal loan, you can use the funds from your HELOC for whatever you want. Common uses include debt consolidation, funding home improvements, starting a business, or paying for medical expenses.
If you use a HELOC for home improvements, you may get a tax benefit. You can deduct any interest paid on a home equity loan or a HELOC if it is used to buy, build, or improve the home that secures the loan. You’ll also get the same benefit if you use a home equity loan for home improvements.
Some HELOC lenders will have introductory offers, such as waived fees or a lower interest rate for a certain amount of time, in order to attract customers. While you shouldn’t let the presence or absence of special offers be the sole deciding factor when choosing a HELOC lender, these offers can be a good way to save some cash upfront. Just be sure to shop around with multiple lenders and compare their rates and fees before making a decision.
Larger loan amount
Because HELOCs are secured debt products where your home acts as collateral — meaning the lender can seize it if you default on your debts — HELOCs tend to offer larger home amounts than typical credit cards or personal loans. How much you can borrow with a HELOC depends on how much equity you currently have in your home. Most lenders will require a loan-to-value ratio of 80% or less, meaning that all the debts secured by your home — including your primary mortgage, the HELOC you plan on taking, and any other debts secured by your home — must not exceed 80% of your home’s value. The exact borrowing limits can vary by lender and may also depend on your credit score and income.
For example, if your home is worth $500,000 and your remaining mortgage balance is $300,000, you have $200,000 equity in your home. If your lender requires a maximum loan-to-value ratio of 80%, you can take a HELOC worth up to $100,000.
Variable interest rate
Most HELOCs carry variable interest rates, unless you specifically choose a rate-lock option offered by some lenders. This means that your interest rate will be based on the prime rate plus a margin, and could change in the future as market conditions cause the prime rate to fluctuate. Most HELOCs come with an interest rate cap to prevent crazy rate swings, but there’s still the risk that your monthly payment could become unaffordable in the future if your interest rate suddenly changes.
Right now, rates are trending upward, so make sure that you fully understand the terms of your HELOC and that you’re prepared to handle any potential rate hikes. If you want the stability of a fixed interest rate, consider getting a rate-lock option on your HELOC (if your lender allows) or a home equity loan instead.
Minimum withdrawal requirements
Unlike credit cards and personal loans, which are good for smaller loan amounts, HELOCs may have minimum withdrawal amounts that require you to borrow a certain amount of money. HELOCs may also come with rules that require you to keep your line of credit open for a certain amount of time.
There is a set draw period
You will only be able to access your HELOC for a set amount of time. Most HELOCs use a 30-year model, where you have a 10-year draw period and a 20-year repayment period. After your draw period ends, you won’t be able to access your HELOC anymore and you’ll have to start paying back the funds you used.
Experts recommend that you start making payments on your HELOC principal balance even during the draw period, that way you’re not surprised by a sudden spike in monthly payments once the repayment period begins.
Fees and closing costs
HELOCs can be fee-heavy. Annual fees, application fees, appraisal fees, attorney fees, and transaction fees can add up. Not every HELOC lender will charge all of these fees, but make sure you know what fees could apply to you. Some lenders may waive these fees altogether, while others may waive them under certain conditions — such as if you keep your account open for a certain amount of time.
You risk losing your house if you default
It’s important to remember that a HELOC is secured by your home, which means if you default on your payments, the lender can seize your house. And, like any other loan, late or missed payments will damage your credit score.
Longer application process
Because HELOCs offer larger loan amounts than personal loans and credit cards, you’ll typically have to go through a lengthier and more complicated process to get approved for one. From application to closing, it can take a few weeks to two months to get a HELOC, experts say.
In addition, since a HELOC is secured by your house, your lender may require you to undergo a home appraisal, adding an additional step and extra cost.
Alternatives to a Home Equity Line of Credit (HELOC)
A HELOC is a good way to borrow money at a comparatively low interest rate, but it’s not the only option. Here are some other popular ways to tap into your home equity or secure the funding you need:
Cash-out mortgage refinance
A cash-out mortgage refinance involves taking out a home loan that’s larger than what you owe on your current mortgage and getting the difference in cash. A cash-out refinance is a good option when interest rates are low or if you’re already planning to refinance for other reasons, but they’re less advantageous right now as mortgage rates have risen dramatically over the past few months and are projected to keep rising.
Home equity loan
A home equity loan is an installment loan that’s secured by your house. You’ll get a lump sum payment upfront that you can use for whatever you want, and then you’ll have set monthly payments until you pay back what you owe.
Unlike a HELOC, a home equity loan has a fixed interest rate. This means that your interest rate and monthly payment won’t change, even if market interest rates increase.
A personal loan is an installment loan that lets you borrow a lump sum of money upfront, at a fixed interest rate, and pay it back in monthly installments. Unlike a HELOC, home equity loan, or cash-out refinance, a personal loan is typically unsecured and requires no collateral. This makes them riskier for the lender, which is why personal loans tend to have higher interest rates and require a good credit score for approval. Some lenders will issue personal loans to lenders with fair or poor credit, but that comes with a higher interest rate.
If you have home equity to tap into, a HELOC can be a good option to fund larger projects like home renovations or consolidating debt. But HELOCs are not without risk, and you could seriously damage your credit and even lose your home if you default.
Frequently Asked Questions: FAQ
Is it worth getting a HELOC?
A HELOC could be a worthwhile borrowing vehicle when you use it for certain things. For example, using a HELOC on home improvements that also improve the value of your home should see a return on investment later if you sell. The biggest pitfall of a HELOC is using it for frivolous things, such as vacations or weddings. Overall, it’s best to refrain from taking on more debt if you can’t afford the payments.
Can you pay off HELOC early?
Yes, you can pay off a HELOC early. However, watch out for prepayment penalties. Some lenders charge a fee for paying before the repayment period, and some do not.
Is it better to get a HELOC or a home equity loan?
That depends. Both loans let you borrow a lump sum to use for various reasons and both are secured by your home as collateral. The main difference is that a home equity loan works like an installment loan, similar to a personal loan, where you pay interest on top of the loan amount in monthly installments over a set period of time. A HELOC, on the other hand, works more like a credit card. You get approved for a certain amount, and spend as little or as much of that limit as you want and then pay interest on what is spent. Which is better depends on what you need the funds for and what interest rates are at the time. Home equity rates are usually higher, but fixed, and HELOC rates are lower, but variable.