HELOC Pros and Cons
Few major decisions are a slam dunk. If they were, life would be a lot less complicated. But most of the time, you need to weigh the pros and cons before making a choice.
Getting a HELOC, or home equity line of credit, is a major financial decision. You need to decide whether to seek a loan in the first place, and whether a HELOC is the best choice among your options. Would a standard home equity loan be better? A cash-out refinance? Or maybe just put it all on a credit card?
To help you sort it through, here's a baker's dozen of the advantages and disadvantages of taking out a HELOC.
First, the upsides:
1. No closing costs
If your credit is good, you won't pay any closing costs to set up a HELOC. That means no application fee, and no closing or appraisal costs. You usually have to pay those with a standard home equity.
2. No fees for cash draws
Credit cards often charge a fee for taking a cash advance, and some checking accounts tack on check-writing fees. By contrast, you shouldn't have to pay a fee to draw funds from a HELOC. If a lender wants to charge a fee each time you take out money, that's a good sign to look elsewhere.
3. Low interest rates
HELOCs can offer some of the lowest interest rates around. Because they're secured by your home equity, their rates tend to be much lower than those on unsecured loans like credit cards or personal loans.
As adjustable-rate loans, they can also give you a lower rate than you can get on a standard fixed-rate home equity loan, though their rate can fluctuate over time. All HELOCs are required by law to have a cap on the maximum the rate can increase over the life of the loan and many will have quarterly limits as well.
4. Converting to a fixed-rate product
Many HELOCs have a provision that allow you to convert your adjustable-rate debt to a fixed-rate loan if you want to lock in a rate. This often happens automatically when you enter the repayment phase of the loan, but many HELOCs also allow you to convert your loan balance to a fixed-rate whenever you wish.
5. Pay it off when you like
You should be able pay off the balance on your HELOC whenever you wish. Talk to a loan officer before you close the mortgage, and be certain that there are no fees for paying off your loan early. Be aware, though, that some HELOCs will charge a fee if you do not maintain a certain minimum balance or draw a certain minimum of funds per year.
6. Tax advantages
Because it's a type of mortgage, the interest you pay on a HELOC or a standard home equity loan is tax-deductible for borrowers who itemize. A couple filing jointly can deduct the interest paid on up to $100,000 in home equity debt, while for single filers the maximum is $50,000.
7. You can use it as you wish
Unlike many other types of loans, you don't have to justify your plans for the money with a HELOC. While most borrowers go into a HELOC with a certain plan for the money, once the line of credit is set up you can use the money as you wish, without having to get any changes approved by your lender.
…and the downsides
While there's a lot to like about HELOCs, there are potential pitfalls to look out for as well. Most can be avoided with a little planning, but you definitely want to be aware of them going in.
8. The low-payment temptation
A HELOC has a very attractive feature – during the draw, your minimum monthly payment need only cover your interest charges. You could have a $25,000 loan balance and be paying less than $80 a month. Over the long haul, however, if you make only the minimum payment, you'll never pay off any principal, and the loan will never go away.
9. Interest rates may rise
Because they're adjustable-rate loans, HELOCs can start out with very low rates. By contrast, fixed-rate loans are priced higher to account for the possibility that interest rates may rise down the road. But if interest rates rise down the road, adjustable-rates will follow, meaning you'd end up paying a higher rate than you started out with.
Though rates have been stable in recent years, they can rise fairly quickly if inflation kicks in. If that starts to happen though, most HELOCs will give you the option of converting your loan balance to a fixed-rate loan.
10. Using your home as a piggy bank
A HELOC can be a smart choice if you're borrowing for home improvements, launch a business or pay for an education. Those types of investments can pay dividends over time. But don't merely use your home as a piggy bank for immediate wants. A Hawaiian vacation may buy you some great memories, but your debt will stay with you until the last cent is repaid.
11. Payment shock
This is what can happen when your reach the end of your draw period and have to begin repaying your loan principal, instead of just covering the interest. All of a sudden, your monthly payments jump from a few dollars a month to hundreds. And it can be made a lot worse if you've succumbed to the temptation of gradually borrowing more than you originally planned, and if you haven't paid attention to the effect of rising interest rates.
Many borrowers will opt to refinance into a new HELOC at the end of their draw period. That allows you to continue making only interest payments, but unless you start paying down your principal as well, you'll only be deferring the problem.
12. Beware hidden fees
Lenders make their money from the interest and annual fees on a HELOC. They lose money if you cancel or refinance a HELOC before the draw period ends. Many will therefore charge an early termination fee. Others may charge additional fees if you don't maintain a minimum loan balance or fail to borrow a certain amount each year. Before you take out the loan, check for hidden fees and make sure you know just when you can be charged additional fees and how much.
13. Losing home value
Another risk is that your home may decrease in value, eroding the remaining equity that you have. This can particularly be a problem if you were counting on selling the house or refinancing to cover the loan.
In some cases, you could even end up underwater on your home loans, owing more on your mortgage and HELOC combined than your home is worth – a situation that many found themselves in after the 2008 crash. This is the major reason not to borrow against more than 80 percent of your home's market value, so you have at least 20 percent equity remaining as a cushion.
HELOCs have plenty of upside; but every homeowner's situation is different. As with any financial tool, you need to consider all the potential risks, as well as the rewards. A HELOC is a great option-just make sure it's the right one for you.