The pros and cons of a home equity line of credit
Have a major expense coming up? Not sure how much you might need, but suspect it’ll be big? Learn about the power of a home equity line of credit (HELOC).
When does a home equity line of credit make sense?
Part of the financial power of home ownership resides in your home’s equity. Unlike rent, which goes into a landlord’s pocket, the equity you build in your home can be a useful financial tool when the time is right. Home equity is defined as, “a homeowner’s unencumbered interest in their real property—that is, the difference between the home’s fair market value and the outstanding balance of all liens on the property.” (Source: Wikipedia)
A home equity line of credit (HELOC) is a useful way to access the equity in your home. Unlike a home equity loan (HEL), the HELOC operates more like a credit card. Rather than draw a fixed amount at one time, you’re able to draw on the line as-needed. Like a credit card, though, a HELOC can be risky. Since your home secures the line of credit, a failure to keep up with the payments can put your home on the line.
A typical HELOC allows you to access up to 85% of your home’s value, minus the outstanding balance on your mortgage. This can be a huge pool of credit to work with, depending on your equity position.
There are some benefits to HELOCs:
- You only pay interest if you draw on the line of credit
- You can pay off your balance and borrow again as needed
- Interest rates tend to be low, as the credit is secured by your home
- It’s easy to draw funds (many even come with a card)
- The interest is tax deductible
There are times when a HELOC is a bad idea, though:
- You only need access to a small amount of money. The fees associated with securing a HELOC make this impractical.
- You may be tempted to treat the HELOC like a credit card, creating a real spending problem
- Monthly payments can fluctuate since the interest rate is variable and tied to the prime rate
- Your income is unstable. You must feel confident you can make those payments.
- There may be a cancellation fee
It’s worth noting, your loan’s interest rate isn’t just the prime rate, but the prime plus the bank’s “margin” (an amount of interest they add to the prime rate). Sometimes banks offer a low introductory margin, and then up the rate later. Be sure to read the terms of any HELOC carefully.