A home equity line of credit, also known as HELOC, has emerged as a go-to option for homeowners wanting everything from expansive kitchens to a new roof. Deciding on which line of credit or whether to use another loan product to finance home improvement projects can be complicated. By understanding what a HELOC is, how it works, and the pros and cons of using it to finance a home improvement project, you'll be able to make an informed financial decision.
A home equity line of credit — commonly called a HELOC— allows property owners to borrow money against what is most likely their largest investment, their house. As homeowners pay down their mortgage and property values increase, the growing equity emerges as an asset that homeowners can access. Simply put, the equity in a home is determined by subtracting the outstanding mortgage balance from the property's appraised value.
Equity ranks among a homeowner's top resources in terms of borrowing power. Lending institutions recognize a home's equity as collateral that can be used to secure a HELOC or other loan product. There are significant differences between a HELOC versus other financing options.
A HELOC is much like a credit card; it has a borrowing limit that homeowners can access all at once or in varying amounts. As payments are made, the amount of available credit increases and the line of credit becomes available to use again.
There are different phases associated with a HELOC. The first phase is the draw period; this phase begins as soon as your HELOC closes. During the draw period you can draw on the available funds. Payments are required during the draw period, but only on the amount of money you have drawn, not the entire line of credit available. When the draw phase ends, the repayment phase begins. During the repayment phase, you may no longer draw on any available funds; repayment of the outstanding funds will begin.
Some home equity lines of credit offer promotional rates for a limited period and typically require a large sum ($10,000 up to $50,000) to be drawn at closing. These promotional rates may be adjustable or fixed and convert to the defined adjustable rate for the remainder of the draw period. Just because the interest rate is lower, if you don't need to use the funds immediately, don't be enticed by a promotional rate that requires you to borrow the funds right away. Why pay interest on funds you don't need?
As you can see, a HELOC can be structured quite differently from other fixed-rate loan alternatives and from lender to lender. Knowing all the elements and how they work and the following pros and cons of using a HELOC for home improvement projects can help you decide how best to move forward.
Qualifying borrowers can typically get a home equity line of credit and borrow up to 80 percent of the home's overall value. Keep in mind lenders will evaluate your ability to repay, and the line of credit amount is determined based on this evaluation. The following rank among the top benefits of leveraging a HELOC:
A HELOC can be a cost-effective option with interest rates still relatively low. Many borrowers discover that lenders have also lowered upfront costs and processing fees.
When a HELOC is used to make home improvements, the interest you pay may qualify as a tax-deductible expense. Be sure to consult a tax advisor for your specific situation.
Many other loan products require people to take a lump sum and promptly begin repayment. A HELOC allows borrowers to withdraw only the specific amount they need and pay interest only on these funds; unused funds remain interest-free. As monthly payments reduce the outstanding balance, funds are replenished and can be used again to pay for other planned or unplanned expenses.
Borrow from your HELOC easily with access typically offered by check, transfer, or a credit card linked to the account.
Applying for a HELOC can be done in minutes with the right lender. Community bank lenders know the local real estate market and make decisions locally, and can offer a quicker approval and closing process.
Finish your project ahead of schedule and have some money left over? Consider debt consolidation; save money by paying off higher-interest debt with the remaining funds in your HELOC. Compare the difference between credit card interest rates and the HELOC rate to see if debt consolidation makes fiscal sense.
Another benefit to consider is that consistent repayment can help improve credit scores. Even with all the positive benefits HELOCs offer, it is important to understand and consider all the aspects this and other borrowing options offer to make informed financial decisions.
It’s essential to understand that the perfect loan or line of credit does not necessarily exist. The HELOC has proven benefits, but you need to keep the following elements in mind:
A home equity loan or line of credit involves leveraging your home as collateral. While homeowners generally breeze through the draw and repayment process, there is the risk that you may default on the loan. Some people are uncomfortable leveraging their homes.
If home and property values drop, families can find themselves owing more than their home is worth. Be sure you draw only the funds you need and confirm the home improvements you make will increase the value of your home.
Although interest rates remain low, that could change. The repayment on an adjustable-rate HELOC could rise should the interest-rate climate change.
Not all, but some home equity lines of credit require interest-only payments during the draw period. Interest-only payments may keep your monthly payment low, but your principal balance won't change if you only plan to make these minimum payments. When the repayment phase begins, you may be surprised at how much your new monthly payment increases. Avoid this big surprise; consider a lender with a principal plus interest payment option. Or, in addition to your monthly interest-only payments, consider paying extra towards your principal each month.
As stated earlier, the line of credit amount is based on the equity in your home, and lenders use your home as collateral to secure your HELOC. If you have a first mortgage on your home, the HELOC will be considered a second mortgage. If you need to sell your home unexpectedly, the HELOC, unlike a credit card, does not move with you. You'll need to pay off your first and second mortgages with the proceeds from the sale of your home, reducing the amount of cash you receive at closing. If your HELOC balance is zero, the line will be closed.
Making informed decisions about major borrowing requires due diligence. Review available financing options for your home improvement project, and be sure to take advantage of free online budgeting calculators to see what payment you can potentially afford.
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This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal, or accounting advice. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this information should consult with a financial professional. The information contained in these articles was obtained from sources believed to be reliable and accurate at the time of publishing. We do not represent that it is accurate or complete, and it should not be relied upon as such. All opinions and estimates expressed in this article are as of publication date unless otherwise indicated, and are subject to change.