A HELOC is quite possibly the most flexible and valuable type of loan that you can get. Since it’s secured by your home, it’s only available to homeowners.
What is a HELOC, and when should you consider getting one? Let’s take a closer look.
What is a HELOC and how does it work?
“HELOC” is a common abbreviation for home equity line of credit. It is essentially a credit card that is secured by your home (many even provide you with a debit card to access the equity). For that reason, HELOCs typically carry much lower interest rates than credit cards, and many lenders also offer them with little or no upfront costs.
A big advantage that they have over traditional credit cards is the size of the credit line. While the largest credit card limits may be $10,000 or $15,000, it’s not unusual for HELOCs to go as high as $50,000 or more.
How much you qualify for will of course depend on your income and credit. But it’s also calculated based on the value of your home.
For example, let’s say that a bank will lend up to 85 percent of the value of your home. If your home is worth $200,000, that means you can borrow up to $170,000.
But if you already have a first mortgage of $120,000, the bank will limit the HELOC to $50,000 ($170,000 minus $50,000).
Interest rates can run as low as 3.99 percent, and are almost always variable rates. Meanwhile, loan terms can vary considerably from one lender to another. For example, one lender may require full repayment within 10 years, while another may allow up to 20 years.
A common arrangement is an interest-only period
A lender may require that only interest be paid back during the early part of the loan, say the first five years. If it is a 15-year loan, they will require that the principal be paid off during the remaining 10 years.
One of the biggest advantages with HELOC’s is in the flexibility of the loan purpose. You can typically use the proceeds of a HELOC for just about anything.
Where to get home equity lines of credit
For starters, if you want to access your home equity without taking on more debt (or paying hefty interest for it), you might consider another option called equity sharing, which allows you to sell a portion of your home’s future value for cash.
Hometap offers this, essentially becoming a co-investor in your property. You get the cash now (up to 15% of your home’s current value), and once you’re ready to sell, Hometap will take its cut of the profits. If you don’t sell within 10 years, you can also buy the company out.
HELOC interest is tax deductible
IRS regulations allow you to deduct interest that you pay on mortgage indebtedness that is not used either to purchase or improve your primary residence, if the interest is paid on a loan amount that does not exceed $100,000.
That means that you can borrow up to $100,000 against a HELOC for purposes that are completely unrelated to your home, and still deduct the interest that you pay on the loan balance.
When a HELOC makes sense
While it’s true that you should generally avoid going into debt, there are times when a HELOC makes sense, particularly in light of the alternatives.
Making improvements to your home
One of the reasons why using a HELOC to make improvements to your home makes sense is because you’re essentially borrowing the money against your home, but then reinvesting it in the home.
A HELOC will make even more sense for this purpose if the improvements you’re making add significant value to your property. That helps to preserve your equity position even as you access the credit line.
Consolidating high interest credit cards
If you have a HELOC available at an interest rate of five percent, it makes a lot of sense to consolidate credit card debts that have interest rates of between 15 and 20 percent. The decrease in your monthly payment due to the lower interest rate will enable you to pay off the debt more quickly.
Paying uncovered and necessary medical expenses
Understand that we’re not talking about cosmetic surgery here, but rather the type of medical expenses that are life-sustaining.
It’s unfortunate, but in today’s health insurance system, deductibles and copayments can be painfully high. In addition, it’s not at all unusual to find that certain necessary procedures are not covered by your insurance. Using a HELOC to pay these expenses can make perfect sense.
Using a HELOC as a back-up emergency fund
Notice that we’re not talking about using a HELOC in lieu of an emergency fund, but as a back-up. That means having it available strictly as a second line of defense in the event that you are hit with a large, unexpected emergency.
Emergency fund amounts are typically based on estimated expense scenarios. But that doesn’t mean that those scenarios will never be exceeded. While the usual recommended emergency fund balance of three months of living expenses may be sufficient in the normal course of events, it’s never a bad idea to have an open credit line ready to access in case an expense is substantially larger.
The downsides of a HELOC
So far we’ve been discussing the virtues of HELOC’s, but there are some downsides you need to be aware of.
Variable interest rates
Like most credit cards, HELOC’s typically have variable interest rates. That means that while a HELOC can start out at a very affordable 4.5 percent, there’s no guarantee that it won’t go to nine percent at some point in the future.
A HELOC may have interest rate caps that limit how high it can go. You should check with the bank to make sure that such limits are in place, and know exactly how high they can go, and under what circumstances they will increase.
Some HELOC’s have balloon provisions. That means that you may be making very low monthly payments that are insufficient to pay off the loan within the stated term.
Say you borrow $50,000, and the loan has a term of 15 years, if you still owe $20,000 at the end of that term, you’ll have to make a lump sum payment to pay the HELOC off. Again, that’s a provision that you need to be aware of before you even sign up for the loan.
Reducing the equity in your home
It’s important to understand that any time you borrow against a HELOC for any purpose, you’re reducing the equity on your home. This can be a serious problem if you’re planning on selling in the near future. It’s an even bigger problem if your home is the primary asset that you have. Each time you borrow against the line, you’re reducing that ownership equity.
Putting your house at risk
Any kind of loan against your home puts your property at risk. Naturally, the higher the indebtedness on the home, the greater the risk. Should the value of the property fall to below the total amount owed on it, you will be underwater on the property. That means that you will owe more on the house than it’s worth. That will make it difficult and maybe even impossible to sell or refinance your home.
Wisely used, a HELOC can be the most valuable and flexible credit arrangement that you have. Just make sure that you avoid using it for the wrong purposes, and that you always have a concrete plan for how you will repay the money borrowed against it.
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