Determine if a HELOC is a good idea for your financial goals. Review pros, cons, and factors to consider when leveraging home equity.
With the holidays over and the promise of new opportunities ahead of you, the New Year can be a great time to take on your biggest projects and chase your most audacious goals. If these projects and goals include renovating your home or consolidating high-interest debt, financing may come from an unlikely place: your home equity.
A home equity line of credit, or HELOC, can be an effective tool for accessing this valuable equity, but is a HELOC a good idea? Below, we’ll explore the pros and cons of a HELOC to help you decide if this equity-unlocking strategy is right for you.
So, what is a HELOC exactly? Like a home equity loan, a home equity line of credit allows homeowners to borrow against the equity they’ve accrued over years of ownership. While a home equity loan gives borrowers their funds via a single lump sum, HELOCs allow for a continuous “withdrawal” up to a credit limit over a set period of time. For some homeowners, this can equate to added flexibility. For others, it can present unnecessary temptation for overspending.
As far as potential HELOC pitfalls go, overspending deserves a spot at the top of the list. Any amount borrowed through a HELOC accrues interest—generally at a variable interest rate—and is repaid over two phases: the draw period and the full repayment period. Only interest payments are due during the draw period. However, once the repayment period begins, both interest and principal are included in the monthly payment. This can catch many borrowers by surprise, and variable interest rates can make it difficult (or virtually impossible) to work HELOC payments into a monthly budget.
There are reasons to be wary of HELOCs beyond the risk of borrowing more than you need. Under the right circumstances, a home equity line of credit may still be a good idea to help you accomplish certain financial goals, from improving your living space to getting on top of debt.
Home renovation projects remain the most common use for HELOCs for homeowners across the country.1 While home equity loans can also be useful for those looking to finance costly home improvement efforts, a credit line provides an added advantage, giving borrowers flexible access to funds as a project progresses.
This flexibility means that you can borrow more if your project goes over budget. But it also means that you don’t have to overborrow just to make sure your project is properly funded. And if all goes according to plan, you may even see your equity increase as your renovation boosts the value of your home.
Emergencies can pop up entirely out of the blue. When they do, they can carry a cost that extends far beyond the price of an unexpected medical bill or unwanted home repair, especially if you’re not prepared, as is the case with the 80 percent of Americans who don’t currently have an emergency fund.2
In the absence of an emergency fund many people have no choice but to shift priorities around, taking on credit card debt or falling behind on bills in the process. While a HELOC should not replace an emergency fund, it can present a better alternative to falling into high-interest debt or slipping behind on mortgage and utility payments.
A common use for HELOCs is to consolidate multiple sources of troublesome debt into one, often significantly reducing the amount of interest paid over time.
Homeowners using a HELOC for debt consolidation can pay off credit card balances, personal loans, and even car notes with the money they draw from their home equity. This can make debt feel more manageable, as several monthly payments and a cornucopia of varying interest rates are replaced by one payment and one variable rate.
So, if HELOCs serve such a useful purpose, why isn’t every homeowner using one? Because with home equity on the line, the risks associated with HELOCs can simply be too great to ignore.
Some risks associated with a home equity line of credit have to do with how borrowers use them. Others, like the unpredictability of variable interest rates, are completely unavoidable.
With fixed interest rates, you can more or less anticipate the amount you’ll owe in interest based on your spending. Variable rates, on the other hand, can change from month to month, putting you on constant defense when it comes to establishing and sticking to a budget that serves your financial goals.
A HELOC’s variable interest rates still tend to be the better option compared to credit cards and personal loans. If you’re hoping to avoid uncertainty, especially when it comes to your home equity, a HELOC may not be a good idea.
While HELOCs allow you to tap into your home equity, you’re not actually drawing from your well of equity so much as you’re borrowing against it. Even though this equity isn’t being depleted, your equity may suffer should you decide to sell your home before your HELOC is paid off.
Per the terms of most HELOCs, borrowers must repay the loan before (or upon) selling.3 This means that if you still owe on your loan when you sell, a portion of your sale proceeds will have to go toward paying off the loan. This means you’ll have less equity than you anticipated to go toward your next property, your retirement, or any other potential application you have lined up.
With less of your hard-earned equity than you had planned for, you may be feeling the impact of your HELOC for years after your debt is cleared.
Unquestionably, the biggest risk of all is that a home equity line of credit may just cost you your home.
HELOCs are secured loans and rely on your property for collateral. This grants them relatively low interest rates compared to other loans, but it’s also what makes them riskier to homeowners—especially when paired with the sometimes confusing repayment schedule.
During the draw period, borrowers are only required to pay interest on the amount they withdraw from the credit line. Many homeowners grow comfortable with this manageable payment, only to be broadsided when payments on the principal are due at the close of the draw period. This is where the trouble arises: suddenly on the hook for a monthly payment double or triple the size, borrowers may begin to fall behind on payments, causing the lender to take action and possibly even foreclose on the home.
The situation outlined above is entirely preventable if you thoroughly review the terms of your HELOC and manage your funds with restraint and discipline. However, mistakes happen, emergencies pop up, and unforeseen circumstances can come out of nowhere, and the only surefire way to avoid losing your home to a HELOC is to avoid a HELOC.
Whether a home equity line of credit or not will vary greatly, and the answer to this question comes down to the specifics of your situation. Consider the following before getting a HELOC and deciding for yourself if using this tool is a good idea.
A home equity line of credit can do many things, like financing an addition to your home, supporting an investment opportunity, or consolidating unruly debt. But HELOCs are most effective when used as a tool, not a life raft.
All this is to say: evaluate your current financial situation and consider whether a HELOC would serve as an added perk or a last resort. If the latter is true, you may want to consult a financial advisor or consider financial counseling before making this decade-defining decision.
We’ve mentioned variable interest rates and draw and repayment periods more than a few times. But truthfully, given the importance of these terms, they could probably have been mentioned even more. The fine print that comes with your loan will have an outsized impact on your financial future, and understanding these terms like a true financial expert will be your best defense against any common pitfalls.
Comb through the fine print with a fine-toothed comb. Ask your lender more questions than you need to. And if anything stands out to you as worrisome, go with your gut.
Lastly, when considering whether a HELOC is a good idea, think about where you want to be in 20 years and what long-term financial goals you’re hoping to achieve in that time. Then, determine whether (and how) a HELOC will help you get there. Is your goal to renovate your home and sell it within five years? If so, a 15- or 20-year HELOC likely won’t be the right fit. Is debt consolidation your number one priority? A HELOC may be the right move, but it’s far from your only move.
There are a lot of instances where a home equity line of credit can be a great tool. For each of these perfect fits, there’s an instance where HELOCs can present more risk than reward. If you’re looking for another option that connects you with your home equity, you may want to explore Truehold’s sell and stay transaction.
Truehold’s sell and stay transaction is a simple two-part real estate transaction. You first sell your home, accessing your hard-earned home equity. You can then continue living in the home as a renter, enjoying the comfort of a familiar space and the freedom of life as a renter.* We’ll handle things like property taxes, homeowners insurance, and essential repairs while you tackle your debt consolidation goals and plot out your next step.
If you’re ready to learn more about Truehold’s sell and stay transaction to see how this can help you accomplish your financial goals without the risks of a HELOC, connect with one of our friendly and helpful representatives today.
Disclaimer*: After the home sale, you must comply with the terms of your lease to continue living in the home. This includes making timely payments on your rent for your minimum lease term (which ranges from 6 – 24 months).
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