Advantages & Disadvantages to a Home Equity Line of Credit (HELOC)

It’s no secret that Americans are sitting on an enormous amount of home equity ( nearly $30 trillion!) But sitting is a passive act; you may be wondering whether there’s a way you could make your equity actively work for you. After all, what good is all that accumulating equity if you can’t use it to renovate your home, consolidate your debt, send your child to college, or invest in a new business venture?

If your thoughts have trended in this direction, your research has likely led you to a number of products that can help you tap into your equity to accomplish such objectives, including the Home Equity Line of Credit, or HELOC. In this post, we’ll outline some of the pros and cons to obtaining a HELOC, and help you decide whether it might be a good fit for you.

What is a Home Equity Line of Credit?

A home equity line of credit (HELOC) is a type of loan that enables homeowners to borrow against the equity of their home–in other words, “tap into” it.

In a HELOC, the lender provides a revolving credit line–much like a credit card–with a maximum limit based on a percentage of the home's appraised value and subtracting the balance of the mortgage. During what is referred to as the “draw period,” which is usually the first 5-10 years of the loan, borrowers can use the line of credit to borrow money as needed, up to the approved limit. Typically, during the draw period, borrowers usually only need to make interest payments on the amount they've borrowed that month. After the draw period ends, the repayment period begins. During this phase (usually 10-20 years), borrowers can no longer borrow money, and they must start repaying the outstanding balance, as well as the interest.

HELOCs are commonly used for home improvements, debt consolidation, education expenses, or other large expenses.

Pros of a HELOC

• Low Interest Rates: Generally, HELOCs tend to have lower interest rates compared to other forms of unsecured credit, such as credit cards or personal loans, because the homeowner is staking their home as collateral. This can result in lower borrowing costs for the homeowner overall.
• Tax-Deductible Interest: In some cases, the interest paid on a HELOC may be tax-deductible, especially if the funds are used for home improvements.
• Can Be Used For What You Wish: Borrowers are not limited to any specific use for HELOC funds, and can use the money for virtually any purpose.
• Long Draw & Repayment Period: If the value of the home increases during the draw period, the homeowner's equity may grow, providing additional borrowing capacity if the borrower needs to access more funds. Plus, the longer repayment period allows borrowers to spread out the repayment of the principal over a more extended period, which might make monthly payments more manageable.
• Only Borrow What You Need: Rather than receiving a lump sum, homeowners merely borrow what they need. This minimizes the interest costs associated with the HELOC, and can lead to smaller monthly payments, allowing you to maintain better control over your financial situation overall.

Cons of a HELOC

• Variable Interest: Many HELOCs have variable interest rates, which means that the interest rate changes with the market conditions. These circumstances can make it difficult to properly budget or plan ahead.
• Your Home Is Collateral: If you fall behind or fail to make payments on your HELOC, you will put your home at risk for foreclosure.
• Lower Home Equity: When you draw funds from your HELOC, you are essentially using a portion of your home equity. The amount you borrow becomes a debt against your home, which doesn't technically lower your overall equity, but it does reduce the amount of equity that is unencumbered.
• Risk of Overspending: While the flexibility of the HELOC can seem like a perk, homeowners need to possess high levels of self-control not to be tempted to accumulate more debt than they can afford to repay.
• Minimum Withdrawals: Some HELOCs do have minimum withdrawals during the draw period to ensure that the loan remains profitable to the lender. So while you may only need to pay the interest on that which you borrow, you would be forced to borrow a certain amount.

Should I Get a HELOC?

A HELOC might be a good idea if:

• You want to make home improvements or repairs which can potentially increase the value of your home. This would be considered a wise investment.
• You have high-interest debt that you want to consolidate, such as credit card balances. HELOCs often have lower interest rates compared to credit cards, so you could save money in the long run.
• You need funds for a one-time big expense and have a clear, structured plan for repayment.

A HELOC might be a bad idea, however, if:

• You’re facing financial uncertainty. With a nebulous income, taking on a HELOC could increase your risk of being unable to meet repayment obligations, ultimately resulting in the loss of your home.
• You want to use the funds for discretionary or non-essential expenses, such as vacations or luxury purchases. It's generally advisable to reserve a HELOC for more strategic and essential uses, to avoid needless debt.
• You have a history of poor spending habits. A HELOC may exacerbate these issues.

Alternatives to Home Equity Lines of Credit

If you want to access your equity, but a HELOC doesn’t appeal to you, there are other solutions you should consider.

Home Equity Loan vs. HELOC

A home equity loan provides a lump sum of money upfront, which is typically repaid in fixed monthly installments over a set period. The HELOC, meanwhile, allows you to withdraw what you need, during which time you simply pay interest on that amount. It is only subsequently during the repayment period that you repay the loan itself as well.

Home equity loans tend to have fixed interest rates, unlike HELOCs, which have variable interest rates that may change throughout the life of the loan.

Cash-Out Refinance vs. HELOC

A cash-out refinance replaces your existing mortgage with a new one that has a higher loan amount; you receive the difference in cash. You will repay the new mortgage just as you were the previous one, with a monthly payment that chips away at the principal amount, plus fixed interest.

On the other hand, a HELOC adds an additional monthly payment–first, the interest on that which you borrow during the draw period, and secondly, when you repay the balance (plus interest) during the repayment period.

Reverse Mortgage vs. HELOC

A reverse mortgage is only available to homeowners who are 62 years or older, and involves the lender paying the homeowner, rather than the other way around. The payments can be made either as a lump sum, fixed monthly payments, a line of credit, or a combination of these. Ultimately, the loan is repaid when you sell the home, move out, or pass away.

HELOCs, alternatively, have no age requirement attached to them. The homeowner can borrow however much (or little) they like–up to a certain limit–each month during the draw period, and then they repay the loan during the repayment period.

Personal Loan vs. HELOC

With a personal loan, your creditworthiness and income are the primary factors considered for approval. Such loans are also typically unsecured, meaning they do not require collateral. As a result, their interest rates are usually higher, though fixed.

HELOCs are secured by your home, and that security can procure you lower (though variable) interest rates, and also lead to a higher loan amount. Of course, you are also potentially putting your home at risk.

Equity Sharing Agreement vs. HELOC

In an equity sharing agreement, such as you can obtain via Unison, you receive a percentage of your home’s current value in exchange for a percentage of its future change in value at the end of the agreement. With Unison, you can maintain the agreement for up to 30 years, though you are free to buy out the agreement or sell your home at any time before then. Unison doesn’t demand monthly payments or accrue interest, either.

In contrast, the HELOC monthly payments vary, depending on whether the homeowner is in the draw period (during which they may merely need to pay interest on that which they’ve borrowed), or the repayment period (during which they repay the principal and interest). And don’t forget–the interest rate is often variable, so the amount due will likely change.