Even with the multitude of financing options available today, homeowners have a unique advantage.
After you have built up enough equity in your home, you may be able to borrow that amount through a home equity line of credit or HELOC. Because HELOCs are backed by an asset (your home), they are one of the most popular ways to borrow at lower interest rates – especially when faced with high renovations, tuition, or debt consolidation costs.
HELOCs are generally easy to come by if you already have at least 15% to 20% equity in your home, and can offer certain advantages – such as lower interest rates or longer loan terms – over other forms of financing such as personal loans and credit cards. As a kind of revolving credit line, a HELOC can also offer pure interest payments. And in contrast to an installment loan, borrowers can access their HELOC again and again during the repayment (similar to a credit card).
However, before you take out what is commonly known as a “second mortgage” mortgage, it is important to think carefully about how you plan to use a HELOC and look at some alternatives that will not put your home at risk.
In this article we share six ideas of what a HELOC can be used for. We also offer three alternatives if you think a HELOC is not right for you.
Is a Home Equity Line of Credit a Good Idea for Me?
HELOCs can provide homeowners with much-needed and flexible access to credit on an ongoing revolving basis if they meet the requirements. Once established, these lines of credit can serve as a helpful reserve funding reservoir for projects that exceed your daily budget.
That said, HELOCs have fees and terms that every borrower should be aware of. Depending on the size of your HELOC, you may incur closing costs for applying for and using your credit line. These fees can include the cost of obtaining, subscribing, closing, and recording your loan. In addition, some HELOCs have initial blackout periods ranging from a few months to a few years during which you may be charged an early repayment penalty or an early termination fee to repay the loan or close the line of credit. Different lenders may charge different fees, and some may even waive certain fees altogether. So ask your lender exactly what you will be paying.
Make sure you shop with multiple lenders to make sure you get the best deal. Don’t just look at the prices either; Also, pay attention to the fees and the total cost of borrowing.
Banks typically advertise “toll-free” HELOCs that do not require cash and that are delivered with no prepayment penalties. Your bank can offer targeted discounts based on your existing relationship and balance. Also, some lenders offer introductory pricing that will make the rate even lower for the first few months that your HELOC is open. Do your research before you apply – and remember that even a “free” HELOC will at least charge interest.
Advantages and disadvantages of a HELOC
In particular, HELOCs are known for only offering interest payments, which makes them an even more attractive option for flexible financing. However, according to Casey Fleming, a mortgage advisor for the Fairway Independent Mortgage Company, every benefit comes with a caveat.
“Too many people only pay the minimum payment for their HELOC,” says Fleming. “In the end, they’ll pay for this shopping spree for the next 25 years. Only go this route if you plan to pay off the remaining balance quickly, ”he says.
Here are some additional pros and cons of a HELOC:
Can only offer interest payments for the first year (s)
Can give borrowers access to revolving loans up to a percentage of the value of their home (typically 85%)
Interest is tax deductible if the funds are used to add value to your home
Can be used at will
Interest-only payments require additional discipline and can cause you to spend beyond your means
Might charge closing costs, like a home mortgage (but not always)
You usually need at least 15 to 20% equity in your home to qualify
Failure to pay could result in foreclosure on your home
5 common uses for a HELOC
You don’t have to use a HELOC just for household-related expenses.
If you’re wondering what else you can use a HELOC for, here are a few options:
HELOCs are “especially good for home improvement projects if you don’t know what the final cost will be,” says Michelle Lambright Black, credit expert and personal finance writer. Construction projects have been known to go over budget or change scope halfway, and you don’t want the money to run out before your project is complete.
Many people use HELOCs to consolidate high interest debt and reduce their monthly payments. This strategy can work as long as you have a definitive plan to pay off the debt.
According to Lambright Black, a “hidden benefit” of using a HELOC to pay off credit card debt is that it can improve your credit score. Credit bureaus do not take HELOC utilization into account when assessing credit, so transferring credit card debt to a HELOC could reduce your reported credit utilization. Improving your score like this could help you qualify for better interest rates and terms on other loans.
Buying another property
If you’re looking to buy a vacation home or rental property, a HELOC can simplify the process. Assuming the equity in your home is on par with someone else’s cost, using HELOCs as opposed to a traditional mortgage could help you avoid the typical 30- to 60-day underwriting process.
Assuming you could afford to “pay off” your HELOC, your new home offer could be seen as stronger than competing buyers as it would not be dependent on bank funding.
An emergency backup fund
As a rule of thumb, you should have an emergency fund to cover expenses for three to six months. While this is ideal, the reality is that most families don’t have that much available for emergencies. A HELOC can serve as a backup for your emergency fund in case something unexpected happens.
Cover business expenses
Business owners can often use a HELOC at lower rates than a small business loan. Also, a HELOC doesn’t require your business to be open for two years before approval, like most small business loans do. The HELOC can be used to start a new business, cover ongoing costs or expand an existing business. However, be aware of the risks involved in investing in a company that uses your home as collateral.
Alternatives to a Home Equity Line of Credit (HELOC)
If you need funding but don’t think a HELOC is the best option for you, here are some alternative ways to get the funding you need:
With interest rates near historic lows, refinancing your existing mortgage via cash-out refinancing can result in low interest rates for the next 15 to 30 years. According to Fleming, a cash-out refinance is “a good idea if your current mortgage doesn’t have a low interest rate.” And since a traditional mortgage payment involves both principal and interest, your balance will decrease with each payment. In comparison, payments on a HELOC with interest only during the draw period would not reduce your principal balance.
Credit card 0% APR
Many credit cards offer an interest-free promotional period when you open an account for the first time. These 0% APR promotions can be used for purchases, credit transfers, or sometimes both. Some of these actions can take up to 18 months or more. While some banks charge a 3% to 5% transfer fee, they usually don’t charge a fee for any sales promotions.
“These offers are a good idea if you can pay the balance before the promotion ends,” says Lambright Black.
Personal loan or line of credit
While personal loans or personal lines of credit may have a higher interest rate, they can usually be opened very quickly. In some cases, borrowers can see cash in the bank account on the day of their application.
In the meantime, most HELOCs require an assessment, and underwriting can take a few weeks before the application is approved. Not to mention HELOCs sometimes require you to keep the line of credit open for at least a couple of years. So, if you need quick cash for a specific purpose (and are planning a quick repayment), personal loans may be preferable in this scenario.