Buying a home is the largest investment most people make. It’s also the largest asset most people have. As years of mortgage payments go by, more and more of your money is tied up in your home. You might start looking at your home and wishing you could have some of that equity back.
Maybe your home’s 1970s Formica kitchen desperately needs to be put out of its misery to make way for a top-of-the-line chef’s kitchen. Maybe it’s time to finally build that art studio out back. On the other hand, you might be considering using your home equity—that’s the value of your home minus your mortgage—to cover existing student loan debt or to pay for your kids’ education.
Lenders have come up with a few creative ways to help you tap into your home equity, one of which is a home equity line of credit, or HELOC (pronounced “he-lock”). A HELOC can help you finance large expenses like major renovations, or higher education for you or your children. However, like all financing options, it comes with some risks as well. To make things a little simpler, we’ll walk you through the basics of how home equity lines of credit work.
What are home equity lines of credit?
A home equity line of credit (HELOC) is a type of loan that uses the value of your house as collateral. However, unlike a lump-sum loan, a HELOC works a bit like a credit card: You can borrow money as needed up to the credit limit or equity you own in your home, then pay back all or part of the balance, and then borrow up to the limit again.
The interest rates are usually variable rates, which means even if it starts low, it could go up depending on the market rate. HELOCs are most commonly used to cover the costs of big home expenses, like a major renovation or addition.
How is a HELOC loan calculated?
Taking out a HELOC typically allows you access to up to 85% of the value of your home, minus the amount you still owe on your mortgage loan.
If your home is appraised at $500,000 and you owe $300,000 on your mortgage, your home equity would be $200,000. Depending on your credit and financial history, a lender might allow you to take out 85% of that equity (that would be $170,000, in this example). You could then draw on that amount as you need it.
The “draw period” can last five to 10 years, depending on your lender. Many HELOCs allow you to make interest-only payments during this time. During the subsequent repayment period, you’ll generally make monthly payments until the loan is paid in full. Repayment periods for HELOCs are typically 20 years.
What are the pros of taking out a HELOC?
Low Interest Rates:
Since it uses your home as collateral, a HELOC can cost you less in interest compared with other loans. Because your interest rate will most likely be variable, it may rise and fall alongside the prime rate, but some lenders offer caps on how high your rate can rise.
Take out money as you need it.
Instead of receiving a lump sum loan, you can take out money over time to cover expenses as needed.
Only pay interest on the amount you’ve withdrawn.
With a HELOC, you take out money gradually, which also means you only pay interest on the amount you’ve taken out.
What are the cons of HELOCs?
A variable interest rate.
Even though your initial interest rate may be low, it could go up and down with the prime rate. This means that over time your monthly payment may fluctuate and become less (or more!) affordable.
High upfront costs.
Taking out a HELOC is a lot like taking out a mortgage: There is plenty of paperwork involved, and you’ll have to deal with upfront fees that can cost 2% to 5% of your total line of credit.
Your home is used as collateral.
This means that if you aren’t able to make payments, your lender could force you to sell your home to recover the borrowed funds. If you have an unsteady income, you may want to avoid taking out a HELOC can be riskier because changing interest rates can change your expected repayment amount.
What are some alternatives to HELOCs?
If you’re looking to finance a big-but-not-that-big project, a construction loan in the form of a personal loan might be a better fit. With fewer up-front costs and minimal paperwork, personal loans can be a quick way to access cash. Personal loans can also be a better alternative to a HELOC if you bought your home recently and don’t have much equity in it yet. Instead of tapping the little equity you have, you can continue to let it grow and instead opt for a personal loan.
Another option to a HELOC is a cash-out refinance. A cash-out refinance lets you take out a larger mortgage when you refinance so you can access the cash difference.
They can be especially useful if your home has appreciated in value, and depending on your financial profile, you may be able to get a more competitive interest rate when you refinance your mortgage. (We compare the pros and cons of HELOCs and cash-out refinances here.)
The final option is a home equity loan. These loans are similar to HELOCs in that your home is used as collateral, keeping the interest rates low. The major difference is that a home equity loan gets you a lump sum rather than a line of credit to draw from. Home equity loans also come with a fixed interest rate rather than a variable one.
Ready to take the next step in securing financing? Check out SoFi’s personal loan and cash-out refinancing options and check your rates within minutes.
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