5 Pros And 5 Cons Of A HELOC

One of the first things that may pop into your mind regarding whether a HELOC might be right for you is, how do you even say the word, anyway? This isn't an irrelevant question, since should you find yourself interested in obtaining this financial product, at some point, you'll likely have to communicate with a lender face-to-face and you wouldn't want them laughing at you or, worse, condescendingly correcting your pronunciation. Well, as Dictionary.com informs us, the correct way to say the word is HEE-lock. Okay, having that out of the way, the next pressing matter is to determine just what makes a HELOC, which stands for "home equity line of credit," different from a plain old home equity loan.

With a home equity loan, you borrow a big chunk of money outright – this is usually about 85% of your home's equity, so if you have 20% equity on a home worth $200,000, your $40,000 in equity nets you a loan amount of $34,000. With a HELOC, however, you're not necessarily borrowing the entire amount. Instead, you'll have a line of credit, meaning the option to tap into the $34,000 on an as-needed basis, but you're not obligated to use (or pay interest on) the entire amount. Is a HELOC always going to be a better bet? Not necessarily. As you may have been tipped off by the title, HELOCs do have their advantages, but there are some disadvantages, as well.

Pro: Lower interest rates than other personal loans

A HELOC is, as the name implies, a line of credit secured by your home's equity, which means the bank isn't lending you anything they know you're not able to repay by liquidating your most valuable asset. This fact allows them to lend you the money at a lower rate than would be the case for a more risky (to them) unsecured personal loan. While HELOC rates, like mortgage rates, do tend to fluctuate with the market along with the interest rate set by the Federal Reserve. The interest rate will likely be quite a bit lower than what you'd pay on a credit card balance should you finance your high-dollar expenditures via that route.

As to how HELOC rates compare to those offered on home equity loans, they may often start out lower. Be aware, though, that as a home equity loan is a one-time deal, you'll be able to lock in a fixed rate at the time you obtain the loan. A line of credit, however, is an ongoing loan, so if you tap into the funds or are still paying down the interest at a time when rates are high, you may not get such a great deal.

Pro: Can access the money as you need when you need it

One great thing about a HELOC is that it allows for far more flexibility with your spending than a straight-up loan. Let's say you have some expenses coming up — maybe you want to make some upgrades to your property or maybe you're starting a business. The thing is, you aren't exactly sure when you'll need the money nor how much of it you'll be spending at any given time. In this case, a HELOC can be used as a revolving credit line, one that's comparable to a credit card. You pull some out, you pay it back, then pull it out again the next time it's needed.

What if you don't need as much cash as you think? That's okay, too. A line of credit is basically an agreement with the bank that you can borrow up to a certain amount but it does not obligate you to use the entire loan.

Pro: You don't pay interest on the unused amount

If you take out a home equity loan, the Federal Trade Commission says that you'll often face required points and other associated charges, whereas these are not typically associated with HELOCs. What's more, if you take out a loan for, say, $20,000, you will need to pay interest on the entire amount of the loan. Not so with a HELOC, where interest is only paid on the amount you use. 

If you take out a line of credit for that same $20,000, but you only use $15,000, of it, that's $5,000 of the principal that you don't need to repay (because you never actually borrowed it). At a 5% interest rate, you'd save $2,500 over 10 years on interest alone. Assuming the interest rate doesn't fluctuate too wildly over the course of your repayment period, that would be a total potential savings of $7,500 you'd realize by opting for a HELOC instead of a home equity loan.

Pro: Not too difficult to qualify

One upside of rampant inflation is that if you bought your home a year or so ago, there's a good chance you may have more equity in it than you would have otherwise. In fact, if you took out a conventional home loan with a 20% down payment, you're likely to be starting off with a sufficient stake to qualify for a loan, and it may even be possible to obtain a loan with as little as 15% equity. The only caveat here is that your home can't have decreased in value during the time you've owned it. While this was certainly an issue during the great housing crash of 2008, tighter lending standards adopted since that time mean that we probably won't see prices fall off a cliff like that in the near future.

Besides your amount of equity, a lender will want to look at several other factors, these being your debt-to-income ratio (under 36% is optimal) and your credit score. With the latter, anything over 700 and you're likely good to go, but even scores in the 600s might get you a loan assuming your debt is low and your equity high. When you apply for a HELOC, you'll need to show proof of income and the lender will pull your credit score. But if the numbers look good, you won't have to go through a whole song-and-dance about how you plan to use the money.

Pro: Interest may be tax deductible

One of the best things about a HELOC is that you may be able to deduct some or even all of the interest you pay. Before you get too excited, though, please note the keyword in the previous sentence, that being "may." While the lender probably won't give a hoot how you plan to spend the funds from your HELOC, the IRS most definitely does care, at least if you plan to use it as the basis for a tax deduction.

The interest paid on a HELOC can only be deducted if, in addition to the loan having been secured with a primary or secondary home, the funds are used to make additions or improvements or to finance the purchase or construction of that same home. As per the 2017 Tax Cuts and Jobs Act, this restriction will remain in place through 2026. So does this mean that in 2027 you can deduct the interest paid on a HELOC that you use to finance a trip to Tahiti? Who knows? Tax laws change frequently (and not always in our favor), so don't start planning your island getaway just yet.

Con: There could be fees and penalties to pay

While the HELOC, like a credit card, is a revolving line of credit, there are some significant differences. The upsides, we've already covered — you can often borrow a far higher amount than a credit card company's willing to lend, plus the interest rate may be a lot lower. On the downside, though, while some credit cards charge an annual fee, many do not. However, HELOCs, typically have annual maintenance fees,  whether or not you're tapping into them and they won't offer you any rewards points or frequent flyer miles in return.

What's more, paying down your credit cards quickly could save you a bundle, but this may not be the case with a HELOC. When you first open a line of credit, you'll have a draw period to access those funds, one that typically lasts from 5 to 15 years. During this time you're only required to pay the interest on the amount of money you use, although if you pay anything over this, the excess will go back into your line of credit. Once the draw period is up, the repayment period begins and during this time you'll need to pay back all funds used plus any remaining interest. 

Con: You may be required to withdraw a certain amount

Yet another way that a HELOC differs from a credit card is that, once you've opened up this line of credit, you may be required to use a certain minimum amount right away. With a credit card, you can leave it untouched and not charge anything and the worst that could happen is the bank canceling it due to inactivity. If you're worried about this happening, you can keep easily keep your card active by charging something so small as a Happy Meal.

With a HELOC, on the other hand, some lenders may require you to initially withdraw a portion of the funds from the account. What's more, you can't just use them for a burger and fries — unless you're buying for an entire stadium's worth of people. Plus, if the initial withdrawal amount is a large portion of your credit line, it's possible you won't have a ton of available credit to reserve for a rainy day.

Con: Reduces your amount of equity

You put down 20%, pay a little extra every month, and if you're really fortunate, housing prices have gone up so that your property is now worth quite a bit more than you paid for it. Let's say you now have 50% equity in a home worth $200,000 — that means that your equity stake is $100,000. Well, at least, it is right up until the time you borrow against it. Take out a HELOC of $85,000 and suddenly you only have $15,000 equity left in your home.

Reducing your equity can be a bit of a risk in an uncertain housing market. If your home's value drops below your mortgage's and HELOC's combined balances, you may end up owing more than your home is worth. However, should you be looking to shelter your assets from creditors, a HELOC may make your property less desirable for them to go after. Most states protect a certain amount of home equity, so taking out a HELOC for that specific purpose may not be necessary and is probably not something you should rush into without exploring all of your options as well as their ramifications.

Con: You could lose access to the funds

Once your application for a HELOC is approved and the funds are made accessible, they're yours to make use of for the entire draw period, right? Not necessarily. If you obtain a home loan, the entire amount you borrowed is in your hands right away, but the potential funds in a HELOC are subject to change at the bank's discretion. This means that it's possible that before the draw period is up, you could be notified that your line of credit has been reduced or even -– brrr!! — frozen.

A HELOC can be reduced or frozen under certain circumstances such as you losing your job, undergoing an expensive divorce, or suffering a big drop in your credit rating (perhaps by robbing Peter to pay Paul as you fail to make timely payments on other debt in order to keep up the HELOC payments). 

You could also lose access to your equity-backed credit line if your home's value tanks. Even if your credit line is frozen, you'll still need to pay down the amount you've already borrowed as well as any interest assessed. But you may want to contact the lender to either appeal the decision or see what you can do to remedy the circumstances that led to it.

Con: You could lose your home if you default

The main reason why a home equity line of credit may not be the best financial product for you is that your home is the collateral. This means that if you fail to keep up the payments, the lender may move to foreclose on your home. That's what it means to borrow against the equity — your stake in your home guarantees payback of the loan, but if you won't pony up the cash, the only way for the bank to get that equity may be to force a sale of the property.

Even if there's no foreclosure, which may be the case if the home's value has decreased to the point where you no longer have equity, you're not off the hook. The bank may sell the debt to a debt collector or they may pursue legal action against you. In order to avoid such drastic actions, you may be able to refinance your first mortgage to pay off the HELOC or you may be eligible for some type of loan modification program. Bankruptcy procedures might also be considered as a last resort, but only if you've obtained proper legal advice.