A home equity line of credit, or HELOC, can be a good option to finance a major life expense like a home renovation, consolidate debt or cover an unexpected emergency.
While there can be significant benefits to using a HELOC, they have a notable downside, which is that you must put your home up as collateral to secure your loan.
What is a home equity line of credit (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 and allow you to repeatedly take out money up to your total line of credit during your draw period (usually 10 years), which is the period of time when you can make withdrawals from your HELOC.
In order to qualify for HELOC loan approval, you will 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 to approve you for their lowest rates, but you can qualify with a score as low as 620 with some lenders)
- 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 since they are secured by your home. Since 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 equity 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. Right now, the national average HELOC rate is 7.34%, according to Bankrate, CNET’s sister site. Compare that to personal loans which currently have an average rate of 11.08%, for example.
During your draw period, you can make interest-only payments on your HELOC, which means you can make minimal monthly payments for years, so your loan will have a low impact on your monthly budget. Plus, you don’t have to take all of the money out all at once, and you pay interest only on the amount you’ve withdrawn – not the entirety of your loan, which also helps you save significantly on interest.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, and don’t have to start making payments on your principal loan balance until your repayment period begins (which can last anywhere from five to 20 years). That affords you flexibility in how you use your loan, and gives you time to plan ahead for the larger payments you must make once you enter your repayment period.
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, which puts you at risk of foreclosure if you miss payments or can’t pay back your loan for any reason. 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 raise interest rates at least one more time before the end of 2022.
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 the year but have now surpassed the 7% mark.
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 to offer you a loan, because they can pay themselves back by repossessing 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.
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.
The bottom line
HELOCs are a convenient way to access cash at a relatively low interest rate. They are useful in situations when you need money over a long period of time, and when you may not know exactly how much you need. It’s important to keep in mind that your loan is secured by your home, which means if you miss payments or default on your HELOC, your bank or lender could repossess your property. It’s crucial to make sure you are prepared to manage your line of credit responsibility and have room in your budget for changing monthly payments.