The current housing boom has often been frustrating for homebuyers, but if you already own your home, it’s presented an opportunity.
Higher home values - prices were up more than 20% year-over year in April – means more equity, which you can borrow money against at a relatively low interest rate.
Just because you can borrow against your newfound home equity doesn’t mean you should. A home equity line of credit, or HELOC, might seem like a great idea for homeowners, and they have advantages, but they also have risks. Experts say some uses for them are better than others.
Before applying for a HELOC, think twice about how you plan to use one and explore other alternatives.
What is a HELOC?
As a homeowner, you may have built equity in your home, meaning its current value is more than you owe on your mortgage. Depending on the amount of equity you have, you may be able to borrow against it with a HELOC.
A HELOC is a revolving line of credit rather than an installation loan, like a traditional home equity loan. It functions much like a credit card; the lender gives you a credit limit, and you can use it repeatedly — up to the maximum credit limit. Bruce McClary, senior vice president of membership and communications with the National Foundation for Credit Counseling, said HELOCs have some advantages over other forms of credit.
“A HELOC offers homeowners the flexibility to borrow as needed during the draw period and within the available credit limit,” he said. “That gives the borrower more control over when and how much will be borrowed.”
Before getting a HELOC, make sure you’re able to pay off a loan based on the entire line of credit. That will protect you against the financial danger posed by overspending.
HELOCs are secured lines of credit that use your home as collateral. “Because a HELOC loan uses the home as collateral, interest rates are more competitive than unsecured lines of credit,” McClary said.
Because they’re secured against your home, HELOCs can be risky, says Madison Block, senior communications associate with American Consumer Credit Counseling, a non-profit credit counseling agency. “A major risk of a HELOC is that your home is the collateral,” she said. “You also reduce the equity you have in your home, so if housing prices drop, you may end up owing more than your home is worth.”
During the HELOC draw period, you only make payments against the interest that accrues. Once the draw period ends, you make payments against interest and the amount of credit you used.
What You Should Not Use a HELOC For
Unlike some other forms of debt, HELOCs don’t have restrictions on their use; you can use the line of credit to pay for a variety of expenses. Because of the risks associated with HELOCs – that you could lose your home if you don’t pay the debt back – experts say you should think twice about using a HELOC for the following expenses:
It can be tempting to use a HELOC to consolidate high-interest credit cards or other debt because of their low interest rates. However, that may be a dangerous choice.
Debt like credit cards, personal loans, and student loans are unsecured; if you fall behind on your payments, it will hurt your credit and you may end up in collections, but your property is safe. By contrast, a HELOC is secured. Moving unsecured debt to secured debt can be dangerous because you risk losing your collateral. In this case, that means your home.
“One of the most attractive reasons for using a HELOC to consolidate credit card debt is the low interest rate, but this is another situation where the stakes are raised when unsecured debt becomes collateralized,” said McClary.
Plus, using a HELOC to consolidate debt doesn’t solve the problems that caused you to go into debt in the first place. In fact, it could lead to even more debt.
Instead, explore other options like personal loans or balance transfer cards.
“An alternative to consider would be a balance transfer to a card with lower interest or an interest-free introductory offer,” McClary says. Or consider meeting with a non-profit credit counselor to get personalized advice.
Unfortunately, a vacation isn’t an essential expense — no matter how badly you want a break from work. If you’re thinking of a HELOC as a low-interest way to finance a dream vacation to Europe or a cruise, be aware that taking on debt for non-essentials is rarely a good idea. Worse, HELOC rates are usually variable, which means they change over time. Depending on the lender, the maximum rate can be over 20%.
With a HELOC, you can get low initial payments during the draw period. But once repayment begins and you have to make payments against the principal and interest, rising interest rates can significantly increase your payment amounts — and cause you to repay far more than you initially borrowed.
Instead, focus on cash-flowing your dream vacation by creating a budget and a savings plan. It may take some time, but being able to pay cash for your vacation may be worth the tradeoff.
When you buy a car with a HELOC, you’re using your home as collateral. And you risk fluctuating interest rates, so your payments could increase a great deal.
If you have good credit — or know someone willing to cosign a loan application — you can likely get a car loan with a relatively low interest rate and fixed monthly payments. In fact, the average rate for a new car loan with a 72-month term was just 4.55% in February — favorable compared to HELOCs.
Although HELOCs may seem like a cost-effective financing option for college, federal student loans are likely a better choice. There is no way to defer HELOC payments if you lose your job or become ill, and there’s no potential for loan forgiveness.
Unlike HELOCs, federal student loans provide more protection. You can enroll in an income-driven repayment plan if you can’t afford your payments, postpone payments through federal forbearance or deferment programs, and even qualify for Public Service Loan Forgiveness if you work for a non-profit organization or government agency.
With relatively low rates, the idea of using a HELOC to get cash for investing in the stock market or cryptocurrency can be appealing. However, that’s an incredibly risky strategy.
There is no guarantee of returns with any investment; you always risk losing money. Even if you choose relatively safe securities, there is no controlling the market, and your investment could drop in value. If that happens and your HELOC repayment period begins, you could be short on cash and unable to afford your payments.
Instead, focus on investing money you have — not that you borrow. Set aside some cash from every paycheck to invest, or consider using windfalls like a tax refund to invest in the stock market.
What You Should Use a HELOC For
Although there are some risks associated with HELOCs, there are some scenarios where they can make sense. A HELOC can be a wise choice for the following expenses:
Using a HELOC for home renovations is one of the most common purposes. By completing repairs or remodeling the house, you could make it a more livable home. Or you can complete renovations that improve its resale value, so you can use a HELOC to actually build more equity. As an added benefit, the interest you pay on the HELOC may be tax-deductible.
“If you can afford the payments, a HELOC can be a great way to fund home improvements because you may get a tax benefit,” said Block.
However, be aware that you’re unlikely to get a dollar-for-dollar return on your home renovation costs. According to Homelight, the average return on popular remodeling projects is just 60%. With that information in mind, only do projects that are necessary to make a sale — or that make staying in your current home more appealing. Home improvement projects are likely less expensive than moving.
If you have a medical bill that wasn’t covered by insurance or an upcoming necessary procedure, a HELOC could be a useful option. It has relatively low rates and a lengthy repayment term, giving you more affordable payments. Medical procedures required to maintain or improve your health are a good use of home equity; just be sure you have a plan in place to repay your debt.
A HELOC can be a great way to get money for necessary expenses. However, it’s important to be aware of the risks involved in using this type of credit. Your home serves as collateral, so the lender can foreclose on your home if you miss payments. And with fluctuating interest rates, your rates — and your monthly payments — can go up.
In general, it’s a good idea to only use HELOCs for essential expenses, costs that will improve your net worth, or that are necessary for your health. Home renovations that boost your house’s value and medical bills are generally justifiable uses for HELOCs, while non-essential expenses tend to be riskier uses.
If you do decide to borrow against your equity, do some homework ahead of time.
“Check your credit to see where you stand before going into the marketplace,” McClary says. “Also, make sure you are able to affordably repay a loan based on the entire line of credit, even if you don’t expect that you will use it all.”