Home equity lines of credit (HELOCs) are home loans that allow you to take cash out of your home as needed. A HELOC works a lot like a credit card, in that you put it in place with a maximum allowable balance, and you can draw on that balance and pay it down over a set draw period, typically 10 or 20 years.
Let’s examine reasons to use and not use a HELOC so you can determine if it’s the right loan to meet your financial objectives.
Top Reasons to Use a HELOC
You only pay when you use it. When you get a HELOC, you’re not taking a lump sum of cash out of your home. You’re setting it up as a maximum drawable balance, and if you always left the balance at zero, your payment would be zero. This makes a HELOC a flexible tool to have cash available only when needed. When you do use it, you’ll start getting a monthly statement and the payment will be calculated on the outstanding balance.
Interest-only payment. Some HELOCs allow you to make an interest-only payment. On a HELOC with a $35,000 balance, an interest-only payment is about $85 per month lower than a 20-year fully-amortized payment (a common amortization period for HELOCs that require a fully amortized payment). This is useful if you want to conserve monthly cash, but your lender will qualify you using a fully amortized payment on the HELOC’s maximum balance or an even more stringent qualifying formula. This worst-case qualifying methodology is to protect you from obtaining a loan you cannot afford. If your HELOC has an interest-only payment option and you pay this option, you won’t be paying your balance down. Make sure you find a HELOC lender that will walk you through both options before securing a HELOC.
Investing in a new home. A HELOC is a great tool to access equity in your existing home to buy or put a down payment on a new home, such as a second home or investment property. Home buying can take months, so if you did a traditional cash-out loan to obtain funds for a new purchase, you could be paying for use of those funds long before you ever invested them. Because you only pay on the HELOC when you use it, you can leave the HELOC at a zero balance while you shop for homes, and only use the HELOC funds (and therefore start paying interest and a monthly payment) when you find a home to buy.
Home improvements. Likewise, if you were remodeling slowly over time, you wouldn’t want to pay for use of all of those funds from day one. For example, maybe you were going to redo your kitchen for $25,000, then wait a year before redoing your bathrooms for another $25,000. With a traditional home loan — like a cash-out refinance of your first mortgage — you’d start paying the interest and payments on $50,000 as of day one. With a HELOC, you would use $25,000 for the kitchen, and wouldn’t add another $25,000 to the balance and payment until a year later. This would save you about $100 per month in interest for that year.
Large purchase like a car or appliances. If you plan to finance a large purchase like this, you should compare financing costs with HELOC costs. Often a HELOC will prove to be a competitive option for a purchase like this.
“Fixed-rate advance” aka “fixed-rate draw” option. HELOCs are adjustable-rate loans (more on this below,) but they also have a feature that allows you to fix a portion of the drawn amount. So if you were going to remodel, or buy a car or appliance, you could do so by fixing that portion of your HELOC draw. In our $25,000 kitchen remodel above, you could use a fixed-rate advance option to make that portion of your HELOC fixed. This is a good option if you know you’re not going to repay that sum for a longer period of time.
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Top Reasons Not to Use a HELOC
Rates are adjustable. HELOCs are adjustable-rate loans, and HELOC rates are based on two components: a set base rate called a “margin,” plus a fluctuating rate called an “index.” The index for HELOCs is the Prime Rate, which is a rate that changes as the Fed adjusts rates throughout each year. For the past 20 years, the Prime Rate peaked at 9.5 percent and averaged 5.39 percent. And a common margin is 1 percent. So a common HELOC rate has been 6.39 percent over the past 20 years. This is competitive compared to fixed-rate cash-out loan alternatives, but that’s because we’ve mostly been in a low rate environment for the past 20 years. If the economy improves from here, the Prime Rate — and therefore HELOC rates — would rise, so maybe you’re better off getting a fixed-rate loan now, before that happens. Ask your HELOC lender to compare cash-out loan options for you.
Payments can be higher. As noted in the “interest-only” payment section above, many HELOCs will require you to pay a fully amortized payment, and this amortization period is often 20 years. If you compared this with a traditional cash-out refinance of a first mortgage, which would typically amortize over 30 years, the HELOC payment will be meaningfully higher. Don’t assume a HELOC payment is going to be lower. You must compare options first.
Not always best option when buying a home. A HELOC is a great option for short-term cash needs, especially if you’re going to pay it off quickly. But if you’re using a HELOC to buy a home — which you can do by having a HELOC be a second mortgage — and you don’t intend to pay it off quickly, you may want to consider a fixed-rate second mortgage. As noted above, a HELOC is an adjustable-rate loan, and a fixed-rate loan might be a safer alternative if you’re holding that loan longer-term.
A HELOC is not an ATM. Because a HELOC behaves a lot like a credit card in that you can draw from it as needed, it’s tempting to use it for whatever you need: groceries, clothes, vacations, etc. But doing so depletes your home equity, and if you’re treating your home like a long-term investment, then using home equity to pay for short-term items isn’t going to meet your objectives.