Most people understand the overwhelming benefits that come from home ownership. Every mortgage payment builds equity, creating a forced savings account. There are tax benefits to home ownership, as well as a strong sense of commitment to acquiring and maintaining something you can call your own.
Fewer people are familiar with just how they can make that equity in their home work for them right now, while they still live in the home, instead of waiting for a day, far in the future, when they sell the home and reap the financial benefits.
Commonly called a HELOC, a home equity line of credit allows the homeowner to borrow against the equity already in the home. The benefits to the homeowner can make this option very attractive.
Increase the value of your home.
By taking money out of the home and using it for needed or desired home improvements you can increase the value of your home right now. There’s no need to wait for inflation to do it for you. Smart home additions, upgrades and general improvements will reward you with a higher selling price should you decide to put your home on the market.
Pay off credit card balances and reduce interest.
The interest you pay on your home equity line of credit is tax deductible, while the interest you were paying on your credit card was not. This is a double financial gain.
Finance a child’s college education.
By borrowing from themselves and paying themselves back as they pay off the HELOC, many parents feel they come out ahead on the college debt scenario.
Boost your credit score.
Making your payments on time to your HELOC will boost your credit score. Payment history is important in determining that magic credit score number and keeping up with your HELOC account will be a real plus. Just make sure you’re staying in line with the long-term payoff schedule. Banks may call in a HELOC if they feel you aren’t in control of the payments.
Your HELOC is flexible. Just because the bank agrees to loan you a certain amount of money doesn’t mean you have to spend it right away. It makes a great emergency fund, only to be tapped in times of genuine need. Payments are only made against the amount of money used. If you have a HELOC and never touch it, you simply have money in the bank for a rainy day. Many HELOCs can also be converted to regular mortgages as well.
Consolidate your debt, lower total monthly payments.
Looking for a way to pay off your debt, reorganize your finances, and increase your cashflow? Consider a home equity line of credit. Debt consolidation funding can come from several different sources, including personal (unsecured) loans, secured loans, or even loans from qualified retirement plans. For many homeowners, however, the most attractive and convenient option is to tap into the equity of their home.
Easier approval process than other loans.
Because home equity loans and and lines of credit are secured, they are usually easier to get approved for than other types of loans. If you itemize your taxes, the interest on a home equity loan or HELOC can be deducted in the same way as conventional mortgage interest. In fact, HELOC interest is the only type of consumer debt other than student loan interest that qualifies as a tax deduction.
Lower up-front costs.
Up-front costs are relatively low when compared with a standard mortgage, helpful if you want to use a HELOC to purchase an investment property. For example, the closing costs on a traditional mortgage of $150,000 can range from $2,000 to $5,000, whereas a comparable HELOC can be as low as $1,000.
How HELOCs Work
A home equity loan or line of credit (HELOC) lets you directly access your home’s equity via a credit line from the lender that provides checks or a debit card. You can use the funds to consolidate your debts, including credit card balances, car loans, student loans, and other high-interest debt. Since the interest rate on your consolidation loan will likely be lower than the interest rate on the debts you currently owe, you’ll be able to pay your debts off faster. You’ll also have just one monthly payment to keep track of.
A home equity loan lets you draw money on the equity you already have in your home. Home equity loans are similar to credit cards and other types of consumer debt in that interest is only charged on the amount withdrawn from the plan. Most home equity loans charge a variable rate of interest and low minimum payments. The other main difference between HELOCs and ‘regular’ loans are the calculation of interest. In a regular loan/mortgage, interest is calculated on a monthly basis. Because the balance of a HELOC may change on any given day, interest on a HELOC is calculated on a daily basis.
You usually have 10 years to draw out the equity. This is referred to as the “draw period” (the period of time in which the borrower can draw on the maximum line of credit). You have another 15 to 20 years to repay the loan after the draw period expires (the “repayment period”).
Simply put, it is a loan which is set up as a line of credit for a predetermined maximum amount, using your home as collateral. This is slightly different than a traditional loan, which is for a fixed amount and is paid up front by the lender. With a HELOC, you are able to draw funds from the maximum amount at any time that you need it. Depending on your HELOC arrangement, you will be able to draw on the HELOC by writing a check or using a special credit card.
Your credit limit is based partially on a combined loan-to-value (CLTV) ratio, typically a maximum of 80 to 90 percent of the home’s appraised value. The amount you can borrow will also depend on other factors, such as your credit score and payment history.
Risks with HELOCS
HELOCs do come with risks. The principal risk is that HELOCs are exposed to interest rates and interest rate fluctuations. Changes to interest rates in the market can impact HELOCs far quicker and more sharply than standard mortgages.
Further, many HELOC contracts allow the lender to cut any unused balance in the line of credit. This means that if you do not withdraw the entire sum of money at once, there is a risk that the lender may reduce the maximum balance, forcing you to refinance at another lender or negotiate.
Failing to pay back a home equity line of credit could mean losing your home, so you need to exercise caution and use this tool only when it is absolutely necessary or makes smart financial sense.
Still, lots of perks.
HELOCs are a great way to access capital with reduced interest rates, lower payments, and a tax benefit. Knowing the value you have in your home and choosing to take advantage of your assets to improve your current life requires a certain amount of financial planning, but the final results can be well worth it.
Ultimately, the decision on whether the HELOC is the right financial vehicle for your needs will depend on your unique situation, but having a deeper understanding of HELOCs is step one on your journey to making the right decision for you.
HELOCS vs home equity loans
A home equity line of credit is similar, but not identical, to a home equity loan. Both financial products are secured by the home, but a home equity loan is taken for a set amount of money, and interest starts accruing on it right away.
Home equity lines of credit are different in that homeowners can decide when to tap the money and how much to spend. The bank will establish a limit when the home equity line of credit is approved, and the homeowner is free to spend up to that amount.
The home equity line of credit is also different in that interest is only due on the amount the homeowner actually uses. That provides additional freedom and flexibility when making home repairs, putting on an addition or working with a contractor.
Homeowners should keep in mind, however, that the bank may charge an origination fee when establishing a home equity line of credit. After all, the bank wants to make money, and that fee ensures they do. It is important to read the fine print carefully and fully understand the fees involved before taking on a home equity line of credit.
Should I Get a HELOC?
No matter who you are or where you live, chances are your home is your biggest single asset. It does not matter if you own a small bungalow, a cozy townhouse or a spacious bi-level, the roof over your head represents an enormous source of untapped wealth.
If you want to make the most of your biggest asset and tap the equity you have worked so hard to build up, you might want to consider a HELOC. Whether your ultimate aim is to remodel your kitchen and bath, fix your leaking roof or pay off your high-interest credit cards, it is important to weigh the pros and cons of using a home equity line of credit (HELOC). One of the biggest advantages of using a HELOC to finance home repairs, make necessary improvements and pay off other debts is that these loans generally come with lower interest rates than the debt they replace. If you have $10,000 in credit card debt with an average APR of 18%, using a HELOC to pay off that debt could save you hundreds of dollars in interest over the life of the loan.
Consolidating your existing debts with a HELOC can also simplify your financial life and make it easier to pay what you owe. This is especially beneficial for homeowners who are currently juggling multiple credit card payments, each with its own set of terms and conditions. Taking out a HELOC to pay off those multiple debts can reduce the number of payments each month and make tracking your progress a lot easier.
If you’re looking to do home improvements, but unsure of the costs, a HELOC can be tapped as needed, reducing the amount of interest and lowering the overall cost of borrowing the money. If you are planning to remodel your kitchen but unsure of the final cost, you can use the HELOC to pay the contractor as you go, making the work easier to afford and simpler to track.
It is important to weigh the pros and cons of a HELOC carefully. If you hope to use a HELOC to pay off your credit card debt, you will need the financial discipline to avoid running up further debts after the existing ones are paid off. If you plan to use your HELOC to fund home improvement projects, you should not look at the line of credit as a license to spend too much or live beyond your means.
When properly used and well managed, a HELOC can be a great way to pay down debt, fund home improvements and enhance your life. As long as you understand the rules, and the potential risks, a HELOC can help you lower your APR, reduce your interest rates and even make your home more valuable.