Is a HELOC Right for You?
For homeowners, a HELOC, or Home Equity Line of Credit, can seem like an easy source of extra funds to help cover expenses. You might use HELOC funds to help remodel your home, pay for college, or pay off high-interest debt.
There are a lot of attractive aspects of a HELOC. It works like a revolving line of credit, closing costs are minimal, and you only pay interest on the amount you actually borrow over the life of the loan.
Still, there are things you should know about how HELOCs work, and the process of using the loan, before you apply.
What is a HELOC?
A HELOC is sort of similar to a credit card. You're approved for a credit limit based on certain factors. You can spend as much or as little as you want, as long as you don't go over that limit. Unlike credit cards, though, the amount you can borrow is based on how much equity you have in your home.
The flexibility of a Home Equity Line of Credit could make sense for a few reasons:
- You can withdraw only what you need to pay for expenses, and exactly when you need it.
- You can save money, because you're only charged interest on what you withdraw
- You have the option of making interest-only payments. However, paying more than the minimum due each month will save you on interest in the long run.
How do HELOCs work?
Since a HELOC is based on the amount of equity you've built up in your home, banks generally use a formula that's based on a percentage of your home equity minus your current mortgage.
For example, let's say you have $500,000 in equity, and your current mortgage is $300,000. Assuming you're approved to borrow up to 80% of your equity, then your maximum loan amount would be $100,000. The formula looks like this: (500,000 x .80) – 300,000 = 100,000.
With that $100,000, you can borrow as much or as little as you want, up to the limit. Here's where the flexibility and appeal of a HELOC comes in to play. If you never actually use more than, say, $20,000 of the credit line, you will only pay interest on that amount.
Things to consider before applying
Low interest rates and the flexibility of a HELOC can make them seem like an attractive option right now. But there are always things to consider before you borrow.
Because HELOCs are a secured line of credit, the interest charged on what you borrow is generally lower than an unsecured line of credit (like a credit card). Remember, though, it's your house that's securing the loan. So, if you default, your lender could foreclose on your house.
Which is why it's important to think about how you plan to use the money, as well as your past spending habits. If you aren't sticking to a sound budget, have a history of being reckless with credit, or are currently struggling to pay off debt, a HELOC is probably not a wise financial decision.
Also keep in mind that while interest rates are low right now, they are likely to rise during the life of your HELOC. So, you should also plan for potentially higher payments.
We're here to help
There are many reasons why a HELOC might seem like a particularly attractive option right now: low interest rates, withdraw only what you need, pay interest only on what you borrow.
But a HELOC can also be risky. Interest rates could rise over the life of your loan. Unhealthy spending and borrowing behaviors could potentially get you in to trouble. And considering it's your house that's securing the line of credit, applying for a HELOC is something you want to make sure is right for you.