HELOC stands for Home Equity Line of Credit. When you are a homeowner, then the difference in the amount that you owe with your mortgage to the overall value of the property represents equity that you have in that real estate. Although this number represents a financial asset, it is not one that is liquid. The only way that you can access it is through the use of a lending product which targets this value specifically.
When you take out a home equity line of credit, then what you are doing is taking out a second mortgage on your property. The collateral that you’re using to secure this lending product is the equity amount that you have with your real estate. Then you are responsible for making payments on your first and second mortgage. Failing to do so can lead you toward the foreclosure process and other financial issues.
As with any lending product that involves a tangible asset, there are some specific HELOC pros and cons to consider before you access the financial resources that you’ve built up in your property over the years.
List of the HELOC Pros
1. A HELOC can give you a significant infusion of cash immediately.
If you need to have a large amount of money available for medical bills, renovations, or paying for college for your children, then a home equity line of credit can make that happen for you. Instead of receiving an entire lump-sum payment as you would with a loan, a HELOC works more like a credit card. Your line of credit is the amount of equity that you have. You can choose to use as much or as little as you need to take care of your financial needs. Then you repay the amount as you would any other debt product according to its terms.
2. The interest rate of a HELOC is better than most credit cards.
When you need to get some access to cash quickly, then a credit card can help you to secure purchases without much difficulty. The only problem with this form of credit is that the interest rates can be very high. Homeowners using credit cards in the United States for their expenses were paying a variable interest rate of 17%, whereas the average interest on a HELOC is a variable median of 5.83%. Although individual factors will cause your final terms to vary, most property owners will find that the expenses of a home equity line of credit are much easier to manage than other lending products.
3. Closing costs for a HELOC are usually less expensive.
Some lenders will offer you a home equity line of credit without any closing costs if you agree to keep it open for a specific length of time – usually 5 years or more. The actual expense varies on the provider of the product and your geographic location, so you may want to ask around a little bit to determine who is giving you the best deal. Nationwide Bank charges up to $750 for this lending option, while local banks or credit unions typically fall somewhere between $100 to $500.
You might also have the costs waived if you agree to a HELOC of a specific amount. Some lenders set the threshold as low as $10,000 when you’re seeking a cash infusion to take care of an immediate expense.
4. There are several different borrowing and repayment schedules from which to choose.
The standard home equity line of credit comes with a variety of repayment schedules to consider. One of the fastest-growing lending products in this area is the 30-year HELOC. Before filing an application to access this product, you will want to think about how long you’ll be keeping the line of credit active. If you don’t need to have it open over the lifetime of the mortgage, then consider a shorter repayment term. It might cost a little more with your monthly payments, but it could give you the financial boost that you need.
5. You can borrow up to the maximum amount without repaying the principle.
You will find that there are varying terms in the world of HELOC products when you need to access the equity in your home. Many lenders will allow you to borrow up to the full amount during the draw period while only making the interest payments on the balance that you took out. Once you enter into the repayment period, then your credit line is frozen, and you must pay the principal amount with the interest until you clear the debt. Make sure to work with a lender who won’t penalize you for prepaying your line of credit to reduce the long-term obligations you may have on this product.
6. Most HELOCs have a lower interest rate than fixed-rate loans.
Even though a home equity line of credit provides charges a variable interest rate, the amount that you pay in these charges is significantly less than what you would encounter with a loan instead. During the first quarter of 2019, HELOCs were averaging about 5.5% per customer, while home equity loan rates were hovering around 8.75%. Although the variability often causes the home equity line of credit to have a lower interest rate at first and then a higher one later in its life, some lenders will allow you to lock the rate for a fee.
7. Income stability can help you to achieve a better interest and approval rate.
If you want to get the best rate on a home equity line of credit, then a stable income is necessary. You will need to prove this through verification of your employment. That means anyone who just changed their career, started working after graduation, works as a freelancer, or owns their business will have fewer opportunities to qualify for a great rate even with a robust income profile. You’ll want to have held the same position for 5-7 years while maintaining a 740+ FICO score to ensure that you get a better interest rate and improve your chances of an approval.
List of the HELOC Cons
1. You will need to have a reasonably strong credit history for approval.
If your credit score is below 700 right now, then finding a lender who is willing to work with you on a HELOC could be challenging. There are extenuating circumstances which could make any homeowner eligible for this product, but without great credit, you could find yourself paying an interest rate between 7% to 12% upon approval. Although you will only pay interest on the actual amount you withdraw from the line of credit to use, property owners with poor credit may find themselves being denied for this lending product.
Because a home equity line of credit is treated like a lending product, a FICO score of 740 may be necessary to secure the best rates that are available in the industry right now.
2. There are fees you will want to consider with a HELOC.
The closing costs might be competitive when you start shopping around for a home equity line of credit, but there are fees that you must calculate into the costs as well. You may need to have your property professionally appraised before a lender will agree to provide a specific amount for your HELOC. There are annual maintenance fees to pay on some of these products as well. Wells Fargo charges a $75 annual fee for their HELOC, which is admittedly similar to some credit card options.
The one issue to review in the terms of your home equity line of credit is whether or not there is a prepayment penalty in place. If you close the account too soon or pay off the loan faster than anticipated, then you could encounter a $300 fee like Nationwide charges.
3. The interest rates of a HELOC can be variable.
Although your good credit could secure you a fixed-rate home equity line of credit, most homeowners will find that the only option available to them is one with a variable rate. That means your monthly payments can be unpredictable, especially when the economy is strong and interest rates are rising. Since you’re going to pay more for this lending product than what you would for a conventional mortgage, it may not be worthwhile to pursue this product when rates are high.
Even under normal economic conditions, the average mortgage interest rate is 1% or more lower than what you’ll receive with a HELOC. Because of this disadvantage, most states in the U.S. cap the maximum interest rate at 18%, but keep in mind that it can change monthly. Most interest rates quoted to you are “starter” rates that will increase after a few months of using the line of credit.
4. You can be charged fees even if you don’t use this lending product.
Lenders get their money from you one way or another when you decide to open a home equity line of credit. Even if you never use the product, you will be subject to the annual fees that are charged to the account. If you don’t pay that fee and it becomes delinquent, it could become the foundation of a foreclosure proceeding against your property. That means you must continue to remain aware of all lending products associated with your property to ensure that you don’t start facing a legal battle over a relatively small amount.
5. There are tax limitations to consider with a HELOC in the United States.
In previous years, homeowners could take advantage of the interest payments they made on a home equity line of credit by deducting them on their annual tax return. New laws now eliminate the interest deduction available for any equity loan unless you can verify that the funds were spent on a home improvement that raises the value of your real estate. You might be able to take advantage of tuition payment credits or deductions in some instances still as well, but the primary tax benefit that homeowners got to use for an entire generation is now gone.
6. You can still end up being underwater when you have a HELOC.
If you end up owing more than your home is worth, then that is called being “underwater” or “upside down” with your lending products. This disadvantage means that you will not be able to refinance your mortgage until the situation corrects itself. Selling your home in that situation is challenging as well because your offers may not cover the full amount that is due from your loans. If you find yourself in this situation and struggling to make your monthly payments, then your only out could be to go through the foreclosure process.
Some lenders might allow you to go through a short sale, while a deed in lieu of foreclosure might be an option too, but all of these situations will adversely impact your credit score for an extended time. You could be feeling the effects of this financial issue for up to 7 years, making it a challenge to own another home for at least a full decade after it occurs.
7. It is easier to overspend with a HELOC than a home equity loan.
Unless you practice disciplined spending habits, you might find yourself overspending on your home equity line of credit. If you tap out all of the equity with this product and still find yourself juggling expenses, then the extra payments could become problematic to your financial health. Even if you have the option to make interest-only payments on some products, you’ll likely be spending several hundred dollars more per month because of this debt. It can sometimes take several years to recover from this issue, which is why you should only access a HELOC if your plan is to improve the value of your property or perhaps pay for your child’s college education.
8. You could lose your home if you fail to pay a HELOC.
Because your home’s equity serves as the collateral for this lending product, failing to pay the amount due each month can put your ownership status at risk. Defaulting on your home equity line of credit gives the lender cause to go after your property to repay what you owe. Even if you have your mortgage up-to-date, falling behind on this payment can still initiate the legal proceedings. That’s why using this lending product for debt consolidation is usually not recommended.
Even though an unsecured credit card offers a higher interest rate and you’ll ultimately pay more to accomplish your goals, your property won’t be at risk if you default on that amount. That is why some homeowners ultimately decide to stay away from a home equity line of credit.
9. Your line of credit disappears once you move out of the draw period.
A home equity line of credit will give you a specific amount of time where you can draw on the approved amount from this lending product. If you were given a $75,000 HELOC, then you can access the full amount up until the final day of your draw period. On a 30-year line of credit, you would probably get to access these funds for the first 10 years. Once you move out of this time, then your line of credit freezes, and you can no longer access any additional funds. You must start repaying the amount as if it were a traditional loan.
10. There are limitations on the amount that you can borrow with a HELOC.
You will not be able to access the full amount of your home’s equity even if you have perfect credit. The calculation on what you can receive is partially based on what your debt-to-equity ratio is to determine the maximum amount of your home equity line of credit. If you have a home worth $200,000 and your mortgage is at $100,000, then your ratio is 50%. Many lenders will cap the full amount for great credit in the 70% range, so the maximum value of your HELOC would be $70,000 using this example.
11. If interest rates go down, your locked HELOC just got more expensive.
The benefit of locking the interest rate with your home equity line of credit is that you can keep it at a specific, budget-friendly rate throughout the lifetime of the product. That is particularly useful if you happen to be in an environment where interest rates start climbing rapidly. If the rates begin to fall, then you will end up costing yourself a significant sum of cash. Even if the difference is only one percentage point and we assume that the lender didn’t charge a fee to secure the lock, it will inflate your monthly payment by $100 per month.
If you extend that rate to a 30-year repayment plan, then you’ll pay about $30,000 more in interest over the lifetime of the home equity line of credit.
12. You will need to provide a lot of information for your HELOC.
Most lenders will want an assortment of documents from you to verify your income, credit, and employment status. You’ll need to have your most recent tax returns available for review. If you own a business or work primarily as a freelancer, then you’ll need bank and investment statements available in most circumstances as well. Some applications require contact information to verify your employment status as well. Because it takes time for all of this data to come back, the application process can take several weeks to complete.
If you’re working with a local bank or credit union for your home equity line of credit, then there is an excellent chance that they will want to pull you in for a face-to-face meeting as well.
Conclusion of the HELOC Pros and Cons
If you want to access the equity of your home in a meaningful way, then a HELOC is one of your best options. It allows you to access the exact amount you need for any situation instead of requiring you to take a lump-sum payment like a loan requires. You are only charged interest on the amount you access, and it gives you an opportunity to increase the value of your home to give your equity another boost.
The easiest way to find out how much equity is in your home is to subtract the amount that you owe on your mortgage to the value of your property. Depending on your financial situation, lenders may allow you to tap up to 85% of that figure with a home equity line of credit.
These HELOC pros and cons are essential to consider if you want to access your equity in the near future. Although you won’t receive a fixed rate as you would with a loan, you don’t need to pay interest on the entire amount either. That means you tend to have more flexibility in what you can do with the funds without straining your budget.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.