Is a HELOC a Good Idea?

Home: It’s where the heart (and the equity) is. If you’re a homeowner looking for a flexible financing option, you’ve probably heard about home equity lines of credit (HELOCs). But when it comes to borrowing against the equity in your home, is a HELOC a good idea? Could it help pay off high credit card debt, fund an emergency fund, or even finance an investment property?

While a home equity line of credit can offer you increased financial freedom, whether it’s the right option for you depends on your personal situation and financial goals.

Let’s talk a little about HELOCs and the factors you need to consider before converting your home equity.

What is a HELOC?

A HELOC is essentially a revolving line of credit, similar to a credit card, where homeowners can borrow against the equity built in their home and repay in monthly installments. It could be seen as an alternative to a personal loan or a tool for debt consolidation.

So, how does a HELOC work? At a glance, the HELOC process works in two stages:

• Draw period – This typically lasts between 5 to 10 years, during which you can withdraw funds up to a certain credit limit. During this period, you only pay interest on the amount borrowed, and can opt for interest-only repayments.

• Repayment period – This period can last 20+ years, during which you can no longer withdraw funds and must finish paying off your borrowed funds.

While functionally similar to a credit card, a HELOC is a second mortgage based on the value of your home equity, which is your home’s value minus what you still owe on the primary mortgage.

The Rising Popularity of HELOCs

With the continuous rise in the median value of homes, the popularity of HELOCs has soared in recent years. 

Homeowners are increasingly drawn to these equity-accessing options, as they offer several strategic financial advantages compared to alternatives like standard home equity loans or a cash-out refinance. 

Compounding this is the rising cost of living, forcing homeowners to put off major expenses like home repairs and renovations due to a lack of funds. A HELOC has proven to be a popular, easily accessible (and sometimes tax-deductible) option to tackle larger expenses, or even consolidate higher-interest debt. Keep in mind, however, that certain closing costs may be associated with a HELOC, just as they would with a primary mortgage.

These are just a few of the use cases that have seen HELOCs rise in popularity over recent years—with many homeowners even now turning to them as a hedge against an uncertain economic future.¹

Advantages of a HELOC

Whether you’re seeking a HELOC to fund home improvements, educational expenses, unexpected emergencies, or other financial goals, a HELOC offers numerous benefits that make it an appealing financing option for homeowners. 

Let’s dive deeper into the HELOC pros and cons, starting with its key advantages.

Lower Interest Rates

When it comes to comparing interest rates, a HELOC offers a significant advantage over credit cards. While the average credit card interest rate hovers around 15% to 20%, a HELOC rate generally clocks in at below 10%.²That’s a sizable monthly reduction in interest payments, which can certainly add up over time. As such, using a HELOC could be a way to manage credit card debt more efficiently.

Of course, the exact rates of a home equity line of credit are dependent on a few different factors, such as:

• The loan-to-value ratio
• Which state you live in
• Your credit score

Any one of these can affect the HELOC interest rate you see from your lender. Nonetheless, they tend to be, on average, lower than credit cards.

Flexibility and Accessibility

Another key advantage of a HELOC is the flexibility and accessibility it offers to homeowners. For instance, the loan amount you can withdraw is not fixed and will depend on the available equity in your home. Most HELOC lenders allow borrowers to leverage up to 80% of their home equity, providing a substantial pool of funds to tap into. And again, you only pay interest on what you actually use.

This flexibility is particularly valuable for situations like:

• Long-term, recurring expenses or investments

• Large projects where it may be challenging to determine the exact total upfront 

With a HELOC, homeowners can address their immediate financial needs without incurring unnecessary interest charges on unused funds.

Interest-Only Payments During Draw Period

One attractive feature of a HELOC is the option to only repay on interest during the draw period.  This means that borrowers have the flexibility to choose whether to make full principal and interest payments—or simply pay the accrued interest on the amount they have borrowed.

This flexibility offers two key advantages:

1. Opting for interest-only payments provides greater control over your cash flow, allowing you to reduce monthly payments to more manageable amounts.

2. Since interest-only payments are, again, optional, you can still chip away at the principal before the repayment period, lowering the overall interest paid.

This freedom allows you to adjust your repayment schedule to suit your current financial needs and situation, either through interest-only payments or incremental principal payments.

Disadvantages of a HELOC

For all the flexibility home equity lines of credit offer, it does have its risks and disadvantages. For example, if you’re denied a HELOC, or if you’re seeking a HELOC with bad credit, the process can be challenging. Understanding both sides of HELOC pros and cons can help you make informed decisions and determine whether this or another financing option would best suit your needs.

Let’s explore the potential downsides to utilizing a HELOC.

Your Home as Collateral

One of the primary considerations when opting for a HELOC, like any home equity-based financing option, is that you are essentially putting up your home as collateral. 

In other words, if you, the borrower, are unable to repay the loan for whatever reason, the lender has the right to foreclose on the property.

This underscores the importance of having a repayment plan in place, making informed decisions, and taking steps to mitigate the risks before committing to a HELOC.

Variable Interest Rates

While HELOCs generally offer lower interest rates compared to credit cards, it’s important to note that the monthly rates for HELOCs are not fixed. That can have a few implications:

• Since the rates vary by month, it can be difficult to budget for future payments

• The rate variation may require month-by-month monitoring in order to avoid unexpected financial strain

This also means certain HELOC lenders might offer initially low rates during the first few months, only to hike them up to a higher interest rate later. Thus, careful attention should be given to the fine print before entering a HELOC agreement.

Higher Payments During Repayment Period

After the draw period ends, rather than interest-only payments, borrowers are required to start paying back on principal as well as interest. 

Naturally, these payments are higher than what the borrower might be accustomed to from the draw period, and can potentially put a strain on the monthly budget.

Risk of Over-Borrowing

The ease and accessibility of a HELOC can tempt homeowners into overspending and accumulating more debt than they would otherwise be able to comfortably manage, especially if the HELOC rate increases over time. In particular, homeowners should be mindful of using a HELOC for things like:

• Depreciating assets such as cars or boats
• Vacations
• Other unnecessary expenses

Careful planning and responsible borrowing are needed to avoid potential financial difficulties during the repayment period. 

Factors to Consider Before Getting a HELOC

With a solid evaluation of the pros and cons in hand, maybe you’re still wondering: is a HELOC a good idea for your particular situation.

To answer that question as it relates to your unique circumstances, here are a few factors that are worth considering.

Evaluating Your Finances

Before opting for a HELOC, assess your financial situation, particularly areas such as:

• Level of income
• Monthly expenses
• Existing debt

While HELOCs are a powerful financial tool, at the end of the day, they create debt. An honest assessment is needed to determine whether such debt is feasible and fits within your budget and financial plans.

It might be a good idea to create an emergency fund, manage any existing credit card debt, and consider other options such as a personal loan or debt consolidation program. Furthermore, you should be aware of the closing costs and check your credit report regularly to ensure your credit health is in good shape.

Understanding Your Home Equity

Since a HELOC is a line of credit based on your home equity, a firm grasp of home equity as a concept, as well as your personal level of equity in the home, is essential. Also, lenders typically require a certain level of equity to qualify for a HELOC, so knowing your home’s value and outstanding mortgage balance is essential. The more equity you have, the higher the potential loan amount you might be approved for in a HELOC.

Assessing Your Ability to Repay

A HELOC is a revolving line of credit, and that means anything borrowed will eventually have to be repaid—with interest. Since HELOCs extend years into the future, it’s important to consider factors like:

• Income stability and current debt to income ratio
• Employment status
• Possible changes to your financial circumstances

Evaluating these areas and how they interact with other features of a HELOC, such as the variable interest rate, are crucial. This is especially true considering the full lifespan of a HELOC can extend for 30 years.

Alternative Options

A HELOC is just one of many financial tools you have at your disposal as a homeowner. Home equity is a powerful force, and there are many different ways to convert it into accessible cash. 

While a HELOC may work well for certain situations, you also want to make sure you have thoroughly explored your options—perhaps even alternative options like a reverse mortgage or a cash-out refinance. Or maybe even an alternative you haven’t heard of before.

Consider a Sale-Leaseback as an Alternative

If you’ve found that a HELOC doesn’t align with your financial goals or circumstances right now, or simply want to explore all your options, one alternative that’s worth considering is a residential sale-leaseback. 

If you’re not sure what a sale-leaseback is, also known as a rent-back agreement, here’s a quick rundown of how it works: 

• First, a homeowner sells their property to a company, converting their home equity into cash
• Next, they lease their home back from the company and continue to live in it as a renter

There are many sale-leaseback benefits to explore. Not only does this provide immediate access to funds from your home equity, it also does so in a way that creates zero additional debt or repayment obligations.

Key Takeaways

Is a HELOC a good idea? While home equity lines of credit can offer advantages such as lower interest rates, flexibility, and accessibility, it’s also important to consider the potential drawbacks. 

Understanding your financial situation, evaluating your ability to repay, and exploring all of your options are crucial steps in determining whether a HELOC is a good fit for your needs. 

Should you find that a HELOC doesn’t quite fit your situation at the moment, consider alternatives such as a sale-leaseback, allowing you to access your home’s equity without needing to move out or saddle additional debt.

This article is published for educational and informational purposes only. This content is based on research and/or other relevant articles and contains trusted sources, but does not express the concerns of EasyKnock. Our goal at EasyKnock is to provide readers with up-to-date and objective resources on real estate and mortgage-related topics. Our content is written by experienced contributors in the finance and real-estate space and all articles undergo an in-depth review process.

Sources: 

1. Money dot com. Homeowners Are Increasingly Turning to HELOCs for Extra Cash.  https://money.com/helocs-popularity-extra-cash/
2.  The Mortgage Reports. HELOCs vs. credit cards: Which option is better in 2023? https://themortgagereports.com/98026/heloc-vs-credit-cards