How Does a HELOC Work?

A Home Equity Line of Credit (HELOC) is a revolving line of credit that allows you to borrow against up to 85% of your home’s equity. This equity is the difference between your home’s value and your remaining mortgage balance. A HELOC typically has two phases: the draw period and the repayment period. During the draw period, which usually lasts 10 years, you make interest-only payments on the money you use. Once the draw period ends, you enter the repayment period, often 20 years, where you start repaying the balance in full. It’s crucial to plan ahead, as payments can increase substantially during the repayment phase. Failure to make payments can put you at risk of foreclosure.

Best 5 Ways to Use a HELOC

HELOCs offer high lending limits and flexibility, generally with lower interest rates than other borrowing options. However, they require using your home as collateral. Here are five of the best ways to use a HELOC:

1. Improve Your Home

HELOCs provide flexible funding for home improvement projects, especially those that roll out in stages or have hidden costs. Additionally, interest on your HELOC may be tax-deductible if used to “buy, build, or substantially improve” your home.

2. Do Major Home Repairs

While routine fixes should be covered by your home maintenance budget, a HELOC can help pay for major repairs like a new roof. If these repairs add to your home’s value, the interest may be tax-deductible.

3. Get Ready to Sell

If your home needs sprucing up before going on the market, a HELOC can cover costs like new landscaping or HVAC upgrades, helping you fetch top dollar. You may even be able to pay off your HELOC using proceeds from the sale.

4. Consolidate or Pay Off Debt

Using a low-interest HELOC to pay off high-interest credit card debt can save you money on interest charges and potentially boost your credit score. However, ensure you have a solid plan to pay off the debt without taking on new debt.

5. Bolster Your Emergency Fund

Keeping a line of credit in reserve provides an additional line of defense during financial crises, such as unexpected expenses or sudden unemployment.

When Not to Use a HELOC

While a HELOC can fund almost anything, there are times when it may not be the best option:

Discretionary Spending

Using a HELOC for regular expenses or big-ticket items like weddings and vacations isn’t a good long-term strategy. It moves you away from owning your home and puts it at risk.

Buying a Car

Even in a high-interest-rate environment, a car loan with a comparable APR to a HELOC is likely available if you have good credit. More importantly, the loan will be secured by your car, not your home.

Paying for College

Federal student loans often have lower interest rates and offer protections like deferment, forbearance, and income-based repayment plans. Consider these options before using a HELOC.

Covering Medical Debt

Before using a HELOC for medical debt, contact your healthcare provider and insurance company to ensure you’ve received all entitled coverage. You may also be able to negotiate your bill or set up a payment plan.

Starting a Business

New businesses can be risky. If your business fails, you may not be able to repay your loan, putting your home at risk. Consider other funding options like SBA loans, crowdfunding, or finding investors.

Investing

Using a HELOC to buy investments or an investment property can be risky. If your investments fail, you could lose both your investment and your home.

Is a HELOC a Good Idea?

A HELOC can be a great choice for home repairs, renovations, or consolidating high-interest debt. It can also serve as an emergency funding resource. However, because it taps into your home’s equity, it’s not always the best option for every expense. For big expenses like weddings, cars, college, or starting a business, consider other loan options to keep your home equity intact and avoid foreclosure risks.

Alternatives to HELOCs

If you need to finance a major purchase or refinance debt, consider these alternatives:

Home Equity Loan

Home equity loans are installment loans using your home’s equity as collateral. They offer fixed loan amounts and fixed APRs, providing predictability.

Cash-Out Home Refinance

Refinance to a larger loan and receive the difference in cash. This option makes sense when interest rates are low. However, it resets the clock on your mortgage, extending the repayment period.

Personal Loan

Personal loans offer fixed APRs and require no collateral. While rates may be higher than a HELOC, your home isn’t used as collateral. Personal loans are available for up to $100,000.

Personal Line of Credit

If you have good credit, your bank or credit union may offer an unsecured personal line of credit. Unlike HELOCs, personal credit lines count toward credit utilization in credit score calculations.

Balance Transfer Credit Card

Refinance high-interest credit card debt with a balance transfer card offering a low or 0% introductory interest rate. Pay off the balance during the promotional period to avoid higher interest rates later.

Reverse Mortgage

If your home is paid off or nearly paid off, a reverse mortgage provides regular payments using your home’s equity as collateral. Homeowners must be 62 years or older to qualify.

The Bottom Line

HELOCs offer unique benefits like lower interest rates, funding flexibility, and potential tax deductions. However, using your home as collateral is serious business. If your income fluctuates or you’re at risk of not being able to repay your loan, proceed with caution. To qualify for a HELOC, you’ll need a good credit score and significant home equity. Checking your credit report and score proactively can help you decide if a HELOC is the best fit for you.

For expert mortgage services, contact O1ne Mortgage at 213-732-3074. Our team is here to help you navigate your mortgage needs and find the best solutions for your financial situation.