HELOC Pros and Cons: Is a Home Equity Line of Credit a Good Idea?

A home equity line of credit (HELOC) is a great resource for homeowners who need to borrow money for ongoing expenses. HELOCs offer a number of benefits — from flexible borrowing to low interest rates to potential tax deductions. But there are also disadvantages to consider, including fees, variable interest rates, and the risk of using your home as collateral.

Below, we’ll break down what a home equity line of credit is, how HELOCs work, the pros and cons of a home equity line of credit, and when a HELOC makes the most sense.

What Is a HELOC?

A HELOC is an ongoing line of credit that’s secured by your home. With a home equity line of credit, you can tap into your home equity without taking out a lump-sum loan. Instead, the lender approves you for a max credit limit, and you borrow only what you need, when you need it. As you repay what you’ve borrowed, that credit becomes available again.

HELOCs have two phases: the draw period and the repayment period.

•   Draw period: The draw period often lasts 10 years, but some lenders may have draw periods as short as 3 or 5 years. During this time, you can access funds to pay for almost anything, including home renovations, debt consolidation, and education expenses. During the draw period, you’ll also be making monthly payments; often, these payments cover interest only.

•   Repayment period: Once the repayment period begins, you can no longer make withdrawals from the line of credit. This period, which typically lasts between 10 and 20 years (sometimes even longer), is all about repaying what you borrowed, plus interest. “Anyone who wants to flex good financial habits may find it worthwhile to come up with a debt repayment plan. This might mean paying credit card balances in full and making all other debt payments on time, such as your mortgage and student loans,” says Brian Walsh, CFP® and Head of Advice & Planning at SoFi. That goes for HELOC payments too.

A few key notes about how HELOCs work:

•   Interest rates are typically variable, meaning they can increase or decrease over time.

•   It generally takes anywhere from two to six weeks to close on a HELOC, and you’ll pay closing costs, much like when buying a house.

•   There may be other ongoing fees, including annual fees, inactivity fees, withdrawal fees, and fees for locking in a fixed rate. Often, your home will need to be appraised and you may pay an appraisal fee.

•   Your home serves as collateral on a HELOC. If you fall behind on payments, the lender can foreclose on your home. That’s why it’s crucial to stay on top of payments and borrow only what you can afford to repay.

Pros of a HELOC

Home equity lines of credit offer several distinct advantages. Let’s take a closer look at some HELOC benefits.

Lower Interest Rates Than Other Borrowing Options

HELOC interest rates tend to be lower than most other flexible loan types, including personal loans, personal lines of credit, and credit cards. That’s because your home serves as collateral on the loan, so there’s less risk for the lender.

Flexible Access to Funds

HELOCs are doubly flexible:

•   Flexible use: You can use the money from a HELOC for almost anything. Some people obtain a HELOC for debt consolidation. Other common use cases are ongoing home renovations or repairs and business or education expenses. A HELOC can also provide a financial cushion if you’re on a fixed income and an unexpected expense comes up.

•   Flexible borrowing: HELOCs are also flexible in terms of when you can borrow. Unlike a home equity loan, which has one lump-sum payment upfront, HELOCs have predetermined draw periods, often 10 years, during which you can borrow what you need, when you need it — up to your borrowing limit.

Recommended: HELOC vs. Home Equity Loan

Pay Interest Only on What You Borrow

When you take out a personal loan or home equity loan, interest immediately begins to accrue on the entirety of what you borrow (the principal). That means more interest accrues faster.

When you meet HELOC requirements and get a HELOC, you pay interest only on what you borrow. If you take out a little bit at a time and stay on top of interest payments during the draw period, you can keep the interest in check. And if you end up not needing the full amount you’re approved for, you pay interest only on the money you actually borrowed.

Potential Tax Deduction

As you evaluate pros and cons of a HELOC, don’t overlook possible tax benefits. Though HELOCs have fees and interest, they may actually help save you money when tax season rolls around. According to the IRS, interest on HELOCs is tax-deductible if you use the funds to buy, build, or substantially improve a home. Consult a tax advisor for the latest information, as tax rules change periodically.

Cons of a HELOC

You should consider the drawbacks of a home equity line of credit before applying. Here are the biggest cons of a HELOC:

Variable Interest Rate

HELOC interest rates are almost always variable. That means your rate could go up or down over time.

This is a gamble: If rates decrease, you could save money on interest. But if things take a turn and rates skyrocket, you could end up owing more in interest. What can happen won’t be a surprise, though: The extent to which your rate could rise or fall will be spelled out in your HELOC agreement.

Your Home Is Collateral

Perhaps the biggest drawback of a HELOC is that your home serves as collateral. If you stop making payments, the lender could foreclose on your house, which leaves you without a home and with significant credit troubles.

Risk of Repayment Shock

Because interest rates are traditionally variable and can change over time, it’s almost impossible to predict how much you’ll need to start paying on a monthly basis when the draw period ends. And even then, your monthly repayment amount can change from time to time as interest rates continue to change.

Some lenders require interest-only payments during the draw period. That means you might not make any progress toward your actual loan balance for years. You might be surprised by just how much you owe when the draw period ends.

When Is a HELOC a Good Idea?

HELOC pros and cons include relatively low interest rates balanced against the unknowns of a variable interest rate. So when is a home equity line of credit a good idea? A HELOC might be for you if you want to fund an ongoing home improvement project but don’t plan to tackle all the work at once. The flexible draw period lets you borrow money when you need it — and only what you need. Plus, you’re actively investing in your home; the increased value from the renovations could ultimately offset the interest you’ll accrue when you eventually sell your home.

Some people also rely on HELOCs to pay for ongoing education expenses, as an alternative to student loans. Entrepreneurs may also use a HELOC to launch a small business and keep the lights on until they start to make money.

In these scenarios, the HELOC helps you increase wealth (by improving your home) or avoid costlier loans for investments in education or a business. On the other hand, using a HELOC for a splurge, such as a wedding or vacation, is usually a bad idea.

HELOC Alternatives to Consider

If HELOC benefits don’t add up for you, the most common alternative to a home equity line of credit is a home equity loan. Home equity loans typically have similar eligibility requirements, but instead of a revolving line of credit, they operate like traditional installment loans. That means you get a lump-sum payment up front and then pay it back in monthly installments (plus interest) over a set number of years. While home equity loans have fixed interest rates, they still use your home as collateral.

Another alternative is a cash-out refinance. Instead of taking out a second loan, you refinance your existing mortgage for more than you owe, then pocket the difference as cash. You can use that cash for whatever you want, but keep in mind, your mortgage repayment term starts all over when you refinance, and you’ll be paying interest on a new, higher amount.

If you’re uncomfortable using your home as collateral, other HELOC alternatives include unsecured borrowing options like credit cards and personal loans. These typically carry higher interest rates since the loans aren’t secured by your home.

The Takeaway

How do the pros and cons of a home equity line of credit stack up? A HELOC is a great borrowing option for homeowners with good credit and enough equity in their home to qualify. You can use a HELOC for almost anything, but their best use case is usually ongoing home improvements or any borrowing need where money is needed in increments as opposed to all at once.

SoFi now offers flexible HELOC options to turn your home equity into cash. Access up to 85% of your home equity, or $350,000, to finance home improvements or consolidate debt. Competitive interest rates and repayment terms up to 20 years could result in lower monthly payments versus other loans. And the online application process is quick and convenient.

Unlock your home’s value with a home equity line of credit from SoFi.

FAQ

How does HELOC repayment work?

HELOC repayments typically happen in two phases. During the draw period, you can borrow money as needed, and the lender will either allow interest-only payments or require payments toward the principal as well as interest. Once the draw period ends, the repayment period begins in earnest, and you’ll make monthly payments toward the principal plus interest until the balance is paid in full.

What credit score do you need for a HELOC?

The credit score needed for a HELOC varies by lender. Some lenders allow a minimum credit score for a HELOC of around 640. Others require a minimum score of 680.

Can you convert a HELOC to a fixed interest rate?

Some, but not all, lenders let you convert your HELOC to a fixed interest rate, so you may want to factor this into the pros and cons of a HELOC. Look for lenders that advertise a fixed-rate HELOC conversion option that lets you lock in the rate on all or part of your outstanding HELOC balance. Some may charge a fee each time you lock in a rate or may limit how many times you can convert a balance to a fixed rate.

What are the typical fees associated with a HELOC?

HELOC fees vary by lender, but they typically include closing costs, such as appraisal fees and title search fees. Some HELOCs also charge application fees, annual maintenance fees, early closure fees, or inactivity fees.

How much can you borrow with a HELOC?

How much you can borrow with a HELOC depends on a few factors, including your home’s value, your remaining mortgage balance, and the lender’s own guidelines. Most lenders let you borrow up to 85% of your home’s value, minus what you still owe on your mortgage. This limit is based on your combined loan-to-value (CLTV) ratio, which measures your total mortgage debt — including the HELOC — against your home’s value.

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Photo credit: iStock/InsideCreativeHouse

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