The current real estate boom has often been frustrating for homebuyers, but if you already own your home, it presents an opportunity.
Higher home values - prices are up more than 20% year-on-year in April – mean more equity to borrow against at a relatively low interest rate.
Just because you can borrow against your newfound home equity doesn’t mean you should. A home equity line of credit, or HELOC, seems like a great idea for homeowners, and it has benefits as well as risks. Experts say some applications are better for them than others.
Before applying for a HELOC, think twice about how you plan to use one and explore other alternatives.
What is a HELOC?
As a homeowner, you may have equity built up in your home, which means its current value is more than you owe on your mortgage. Depending on how much equity you have, you may be able to borrow with a HELOC.
A HELOC is a revolving line of credit and not an installment loan like a traditional home equity loan. It works similar to a credit card; The lender gives you a credit limit that you can use repeatedly – up to the maximum credit limit. Bruce McClary, senior vice president of membership and communications at the National Foundation for Credit Counseling, said HELOCs have some advantages over other forms of credit.
“A HELOC gives homeowners the flexibility to borrow as needed during the drawing period and within the available credit limit,” he said. “That gives the borrower more control over when and how much to borrow.”
Before purchasing a HELOC, make sure you are able to repay a loan based on the total line of credit. This protects you from the financial risk of overspending.
HELOCs are secured lines of credit that use your home as collateral. “Because a HELOC loan uses the home as collateral, the interest rates are more competitive than unsecured lines of credit,” McClary said.
Because they’re secured against your home, HELOCs can be risky, says Madison Block, senior communications associate at American Consumer Credit Counseling, a nonprofit credit counseling agency. “A big risk of a HELOC is that your home is the security,” she said. “You’re also reducing the equity you have in your home, so if home prices fall, you may end up with more debt than your home is worth.”
During the HELOC draw period, you only pay against accrued interest. After the drawing period has expired, you pay against interest and the amount of credit used.
What you shouldn’t use a HELOC for
Unlike some other forms of debt, HELOCs have no restrictions on their use; You can use the line of credit to pay for a variety of expenses. Because of the risks associated with HELOCs — that you could lose your home if you don’t pay off the debt — experts say you should think twice about using a HELOC for the following expenses:
With interest rates so low, it can be tempting to use a HELOC to consolidate high-yield credit cards or other debt. However, that can be a dangerous choice.
Debt such as credit cards, personal loans, and student loans are unsecured; Defaulting on your payments will hurt your credit and could land you in debt collection proceedings, but your property is safe. A HELOC is secured against this. Moving from unsecured debt to secured debt can be dangerous as you risk losing your collateral. In this case, this is your home.
“One of the most attractive reasons for using a HELOC to consolidate credit card debt is the low interest rate, but this is another situation where the stakes are raised when unsecured debt is secured,” McClary said.
Also, using a HELOC for debt consolidation doesn’t solve the problems that caused you to get into debt in the first place. In fact, it could lead to even more debt.
Instead, explore other options like personal loans or balance transfer cards.
“An alternative to explore would be a balance transfer to a card with a lower interest rate or an interest-free introductory offer,” says McClary. Or consider meeting with a nonprofit credit counselor for one-on-one advice.
Unfortunately, a vacation isn’t an essential expense—no matter how much you want a break from work. If you’re thinking of a HELOC as a low-interest way to finance a dream European vacation or cruise, be aware that borrowing on non-essential items is rarely a good idea. Worse, HELOC rates are typically variable, meaning they change over time. Depending on the lender, the maximum rate can be over 20%.
With a HELOC you can get low initial payments during the draw period. But once repayment begins and you have to make payments on principal and interest, rising interest rates can significantly increase your payment amounts — and cause you to pay back far more than you originally borrowed.
Instead, focus on financing your dream vacation by creating a budget and savings plan. It may take time, but the ability to pay for your vacation in cash can be worth the trade-off.
If you buy a car with a HELOC, use your home as collateral. And you risk fluctuating interest rates, so your payments could increase significantly.
If you have good credit—or know someone who is willing to sign a loan application—you can probably get a car loan with a relatively low interest rate and fixed monthly payments. In fact, the average rate on a 72-month new car loan in February was just 4.55% — cheap compared to HELOCs.
Although HELOCs may seem like an inexpensive college financing option, federal student loans are probably a better choice. There is no way to defer HELOC payments if you lose your job or get sick, and there is no way for a loan forgiveness.
Unlike HELOCs, federal student loans offer more protection. You can enroll in an income-tested repayment plan when you can’t afford your payments, defer payments through state forbearance or deferral programs, and even qualify for government loan forgiveness if you work for a nonprofit organization or government agency.
When interest rates are relatively low, the idea of using a HELOC to get money to invest in the stock market or cryptocurrency can be tempting. However, this is an incredibly risky strategy.
There is no guarantee of return on an investment; You always risk losing money. Even if you choose relatively safe securities, there is no control over the market and your investment could lose value. When this happens and your HELOC repayment period begins, you could be short of cash and unable to afford your payments.
Instead, focus on investing money you have – not borrowing it. Set aside some money from every paycheck to invest, or consider using lucky breaks like a tax refund to invest in the stock market.
What you should use a HELOC for
Although there are some risks associated with HELOCs, there are some scenarios where they can make sense. A HELOC can be a good choice for the following expenses:
Using a HELOC for home renovations is one of the most common purposes. By making repairs or remodeling the house, you can make it a more livable home. Or you can do renovations that improve resale value, so you can actually build more equity with a HELOC. As an added benefit, the interest you pay on the HELOC may be tax deductible.
“If you can afford the payments, a HELOC can be a great way to fund home improvement because you may get a tax benefit,” Block said.
However, be aware that you probably won’t get a dollar-for-dollar return on your home renovation expenses. According to Homelight, the average return on popular remodeling projects is just 60%. With this information in mind, you should only undertake projects that are necessary for a sale – or that will make your current home more attractive to stay in. Home improvement projects are likely to be less expensive than moving house.
If you have a medical bill that isn’t covered by insurance, or an upcoming necessary procedure, a HELOC could be a useful option. It has relatively low interest rates and a long repayment period, giving you cheaper payments. Medical procedures needed to maintain or improve your health are a good use of home equity; Just make sure you have a plan to pay off your debt.
A HELOC can be a great way to raise money for necessary expenses. However, it is important to be aware of the risks involved in using this type of credit. Your home serves as collateral so the lender can foreclose on your home if you miss payments. And when interest rates fluctuate, your installments — and your monthly payments — can increase.
In general, it’s a good idea to only use HELOCs for essential expenses, expenses that improve your wealth or are necessary for your health. Home renovations, which add value to your home, and medical bills are generally justifiable uses for HELOCs, while non-essential expenses are more risky uses.
If you decide to borrow against your equity, do some homework beforehand.
“Check your credit score to see where you stand before you go on the market,” says McClary. “Also make sure you can affordably repay a loan based on the entire line of credit, even if you don’t expect to use it in full.”