HELOC Pros and Cons
HELOC Pros
Lower Initial Interest Rate and Monthly Payment
The initial interest rate on a HELOC is usually lower than the rate on a home equity loan and in some cases lower than the current market interest rate for a first mortgage. Many lenders offer HELOCs with a loan introductory rate, also called a teaser rate, and then the interest rate increases and is subject to change on a monthly, semi-annual or annual basis for the remainder of the line. The introductory period usually ranges from one month to a year with the shorter the period, the lower the rate. A lower interest rate results in a initial lower monthly payment for borrowers. Additionally, borrowers can select an interest only HELOC in which case their monthly payment is comprised of only interest and no principal during the draw period which results in an even lower monthly payment. Finally, because borrowers can control and lower their loan balance with a HELOC, they can reduce their monthly payment to meet their financial needs.
Ability to Draw Down and Repay HELOC Unlimited Number of Times
The main benefit of a HELOC is that borrowers can draw down, repay and draw down the line an unlimited number of times during the draw period, which is usually the first ten years and one month of the line. This gives borrowers significantly more financial flexibility with a HELOC as compared to a home equity loan or refinance when borrowers receive a fixed amount of proceeds upfront when the loan closes. Additionally, the line offers borrowers greater borrowing capacity than a home equity loan because you can draw down the line multiple times. For example, with a $50,000 HELOC you can draw down $50,000 in years one through ten of the line assuming you have paid down your balance in full in between each draw.
Save Time and Money as Compared to a Refinance
A HELOC saves you time and money as compared to other options for accessing the equity in your home such as a cash-out refinance or reverse mortgage. Closing costs are usually lower than for a refinance because the loan amount is smaller. Additionally, the application and closing processes for a HELOC are streamlined as compared to a full refinance.
Draw Down Only the Amount of Money You Need
A HELOC provides the flexibility to draw down only the amount of money you need at any given point in time. For example, some borrowers may put a line in place even though they have no immediate use of proceeds. In this case, a borrower could have a $50,000 line of credit but zero loan balance when the HELOC closes because they did not draw down the line. With a HELOC, your monthly payment and interest expense are based on your outstanding loan balance so providing the flexibility to draw down the specific amount of money you need when you need it helps you manage your payment and reduce your interest expense. By comparison, with a home equity loan, borrowers receive the full amount of loan proceeds when their loan closes even if they do not have an immediate need for all the money.
Lower Total Interest Expense Over Life of Loan
The total interest expense borrowers pay over the life of a HELOC is usually less than the total interest when you refinance your existing mortgage. This is because a HELOC loan amount is usually smaller than a new mortgage when you refinance -- a smaller loan means you pay less interest expense. Additionally, when you refinance your mortgage you are effectively extending the length of your existing loan unless you reduce your term or loan balance. A HELOC provides a much more precise and cost-effective way to access the equity in your home. Adding a HELOC to your existing mortgage instead of using a cash-out refinance can save you thousands of dollars in interest over the life of your mortgage.
No Restrictions on Use of Proceeds
Although lenders want to understand the use of proceeds for a HELOC, there are typically few restrictions on how borrowers spend the money. Borrowers can use the proceeds from the line for any number of purposes including home improvements and remodeling, college tuition, paying off high interest credit card debt or buying a vacation home. A HELOC affords borrowers significant flexibility on how they access and use the equity in their home.
Increased Borrowing Capacity
The maximum borrower debt-to-income ratio for a HELOC is usually higher than for a mortgage which potentially increases your borrowing capacity. For example, the maximum debt-to-income ratio for a mortgage is usually 43% to 47% depending on several factors including your credit score and loan-to-value (LTV) ratio while the maximum debt-to-income ratio for a HELOC is typically 55%. The higher the debt-to-income ratio, the higher the line amount you qualify for. To determine what size line you qualify for lenders typically focus more on how much equity you have in your home and the combined loan-to-value (CLTV) ratio of your first mortgage plus your the fully drawn line.
HELOC Interest is Tax Deductible in Most Cases
Interest expense on a HELOC is tax deductible as long as the loan proceeds are used to buy, build or substantially improve the property that secures the loan. Additionally, HELOC interest is tax deductible as long as the total amount of loans secured by the property does not exceed the value of the property and the total amount of the loans, including the first mortgage, does not exceed $750,000 (in most cases). For example, if you take out a HELOC to renovate or upgrade your home, then the interest expense on the line is usually tax deductible.
HELOC Cons
Interest Rate Can Change
The interest rate on a HELOC is subject to change and potentially increase on a monthly, semi-annual or annual basis depending on your loan terms. The rate on the line fluctuates based on changes in an underlying interest rate such as SOFR, the prime interest rate or LIBOR, which is being eliminated after 2021. An increase in the index increases the interest rate you pay on your outstanding HELOC loan balance and increases your monthly payment. By comparison, the interest rate for most home equity loans is fixed. Although rate caps usually limit how much your interest rate can increase with a HELOC, borrowers should fully understand the risk involved.
Monthly Payment Can Increase Significantly When the HELOC Resets
Borrowers with interest only HELOCs can experience a significant jump in their monthly payment at the end of the draw period when the loan resets. At the end of the draw period borrowers can no longer draw down on their line and are required to start paying down their line balance. This means that borrowers' monthly payments are comprised of both principal and interest instead of only interest which usually causes the payments to increase significantly. Additionally, the HELOC interest rate can also increase which would cause the monthly payment to go up even more. Borrowers can manage potential payment shock by paying down their HELOC balance before the draw period ends.
Beware Additional Fees
Some lenders charge extra fees including non-utilization fees and pre-payment penalties for HELOCs. Some lenders apply a non-utilization fee if borrowers do not draw down their line or lenders may charge a pre-payment penalty if borrowers pay off their line within a specified period of time. Borrowers should avoid pre-payment penalties and be aware of any extra fees before selecting a HELOC lender.
More FREEandCLEAR Resources
How a Home Equity Line of Credit (HELOC) Works
Review our comprehensive overview of how a HELOC works including types of lines, key loan terms, borrower qualification requirements, interest rates and combined loan-to-value (CLTV) ratio limits.
Home Equity Line of Credit (HELOC) Rates
HELOCs are offered by traditional lenders such as banks, mortgage banks and credit unions with credit unions usually offering the most attractive terms. Use our HELOC rate tables to compare interest rates and fees for lenders in your area. Comparing rates from multiple lenders is the best way to save money on your HELOC.
Comparing a HELOC to a Home Equity Loan
Review our detailed comparison of a HELOC to a home equity loan including interest rate, monthly payment and reasons to use each financing option. Compare a HELOC to a home equity loan to determine the best financing option for you based on your personal and financial objectives.
Best Ways to Take Cash Out of Your Home
Review and compare numerous ways to access the equity in your home including a HELOC, home equity loan, cash-out refinance and reverse mortgage. Understand the positive and negatives of each financing option to select the one that is right for you.
Sources
“My lender offered me a Home Equity Line of Credit (HELOC). What is a HELOC?” CFPB. Consumer Financial Protection Bureau, September 25 2017. Web.