Your home is likely one of your most valuable assets. As such, it might be nice to get some benefit from it from time to time.
If you feel this way, you’re not alone. The St. Louis Federal Reserve reported that, as of March 2018, there’s approximately $371.7 billion in outstanding home equity lines of credit (HELOC).
If you’re interested in tapping the ownership you have to make home improvements or pay off bills, it can make sense to consider whether a HELOC is right for you.
What is a HELOC?
“Basically, a home equity line of credit is a loan that functions like a credit card, but is secured with your home,” said Laura Mael, the public relations officer at Settlers bank. She’s a 30-year banking industry veteran and has experience in mortgage lending.
The amount you can borrow is based on the amount of equity — or ownership — you have in your home. When you buy a home with a mortgage, it’s the bank that actually fronts the money, so you can’t really be said to own the home.
However, as you make payments on the mortgage, and as your home’s value increases, you end up with more equity until, finally, no more money is owed on your home.
Along the way, though, you have the chance to tap into the ownership you’re building with a special loan.
“Banks are happy to dole out these HELOCs because they can come after your home if you don’t pay,” said Terence Michael, a mortgage broker with Omni-Fund.
With a HELOC, you’re offered a line of credit. You’ll pay interest on charges you make. But as you make payments, your funds become available again — without the need to reapply for the loan.
Mael said most HELOCs come with variable rates, and the minimum payment on the loan typically covers interest charges.
How much can you borrow?
As mentioned above, a HELOC is based on how much ownership you’ve built up in your home. With an FHA loan, the maximum loan-to-value (LTV) ratio you can have after a HELOC is 85%.
Other lenders, though, might have other requirements. You might be limited to 80% LTV. Or you could find a bank willing to lend you up to 95%.
For example, let’s say your home is worth $250,000 and you owe $150,000 on an FHA loan. Right now you have $100,000 in equity but want to get a HELOC.
If you can only borrow up to a total of 85% LTV, that limits you to a cap of $212,500 on your total mortgage debt. You don’t have $100,000 available to you. Instead, you can only borrow up to $62,500.
When does a HELOC make sense?
Now that you know what a HELOC is, it’s time to figure out when it makes sense to get one. Here are four suggestions for using a HELOC.
1. Home improvements
Mael said that this approach makes the most sense with a HELOC.
“You might need to make a series of purchases without wanting to reapply for another loan,” Mael said. “Plus, you can increase the value of your home and get a good interest rate.”
When getting a HELOC, though, Mael warned against situations where you might not be able to repay the principal as well as interest.
“If you’re only ever going to make interest payments, the principal will never go down and you risk tying up all your equity into the loan,” she said.
On the other hand, Mael pointed out, your home improvements might increase the value of your home so that when you sell it, the loan is paid off. She suggested carefully considering your situation to avoid borrowing more than you can handle.
2. Paying off student loan debt
Depending on your student loan situation, it can make sense to pay off student debt using a HELOC.
“In many instances, the interest rate on the home equity line of credit is lower than on the student loan,” Mael said.
That was the case for Josh Hastings, the founder of Money Life Wax, a personal finance blog.
“Our big reason for using a HELOC is that our variable rate is at 4.00%,” said Hastings. “Compare that to our federal loan rate, which was 7.90%.”
Using this strategy, Hastings is able to repay his debt more quickly and with lower interest charges:
“By using a home equity line of credit, we are able to pay ahead on our student loans then drive down our HELOC to wash, rinse, and repeat,” he continued. “It has allowed us to get ahead on our student loans while minimizing the interest we pay.”
This isn’t the best strategy for everyone, though. Depending on your credit score and income, it’s possible to get an even lower rate when you refinance your student loans.
Plus, with student loan refinancing, your debt remains unsecured. If you can’t make payments on your debt, you could lose your home. Consider whether you’ll get better results by refinancing or taking on a home equity loan.
3. Consolidating high-interest consumer debt
If you can’t seem to get ahead of your credit card debt, using your home equity to pay it off could help, Mael said.
The lower rate on a HELOC allows you to save on interest while consolidating your debt. However, when you use this strategy, you take on debt secured by your home.
Mael recommended proceeding with caution when using this approach. “Pay down the amount representing credit card debt quickly,” she said. “Stop adding to the HELOC until the portion representing your credit cards is taken care of.”
If you have access to a zero-interest credit card, it can make sense to use it instead of a HELOC. Look for a credit card with a 24-month introductory period so you have time to pay it off while avoiding interest.
Another consideration is to pay off your credit card debt using a personal loan. Depending on your credit situation, you might be able to get a low-rate personal loan for credit card consolidation. Even if you pay more in interest on your personal loan than with a HELOC, it’s still an improvement over your current credit card rates.
Our credit card consolidation calculator can show you how much you could save using a personal loan to consolidate debt.
4. Using it as an emergency fund
Sometimes, big things just happen, Michael pointed out.
“If you need the safety net of having access to a large amount of money because something might happen, such as losing a job, a HELOC is a great option,” Michael said.
In fact, he’s used this strategy himself. “Just like a credit card that sits empty in your wallet, it can be there providing a sense of security,” Michael said. “You don’t have to use it unless absolutely necessary.”
However, when you keep an open HELOC, there might be fees. Depending on the lender, said Michael, those fees can be anywhere between $75 and $200 a year. But if you haven’t saved up a large emergency fund, a HELOC might work as a stand-in until you have built up your bank account.
When to avoid using a HELOC
Access to such a large amount of cash can be tempting. But being irresponsible with a line of credit could lead to financial trouble down the road.
“Just like a credit card, there’s no limit to how you use this money,” said Michael. “That can be an issue. If you’ve maxed out your HELOC and don’t have any increasing or additional income elsewhere to pay the growing bill, you’re stuck — and you could lose your house.”
So while it’s tempting to use a HELOC for any number of purposes, Mael and Michael both agreed that there are some things you shouldn’t tap the equity in your home to pay for:
- Expensive jewelry
- Boat (or other leisure vehicles)
“Instead, save up the money for the things you seek to purchase,” Mael said. “With investments, you can’t be sure your return will always beat the variable rate on your HELOC, and then your home is at risk.”
Mael also pointed out that some things, such as vacations, weddings, and luxury items, can be planned for. She suggested opening a savings account. You can then set up automatic transfers to effortlessly save up for your goals.
Decide if a HELOC is right for you
Whether you have $10,000 or $100,000 available to you with a HELOC, it’s vital that you consider your situation and the purpose of the loan before you sign on the dotted line.
Mael, Hastings, and Michael all pointed out that discipline and planning are needed in order to avoid losing your home down the road.
Shop around for the best rate possible on your home loan to ensure that you’re getting a good deal. Additionally, don’t forget to look at other types of loans. Personal loans, student loan refinancing, and zero-interest credit card offers can all provide ways to help you meet your goals without putting your home at risk.
Finally, think about whether you have time to save up for your goals. While a HELOC can provide cash in a pinch, it might be better to save up for emergencies and plan ahead for big purchases. That way, your home isn’t held hostage.
“What is a home equity line of credit? Basically, it’s the most amazing credit card ever created,” said Michael. “But as with all powerful things, it comes with great responsibility.”
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