Is a HELOC a good idea? Pros, cons, and when it makes sense

For homeowners carrying high-interest debt or facing a major expense, a home equity line of credit could be a practical tool. Here’s how HELOCs work, the pros and cons, the situations where a HELOC tends to make sense, and a practical framework to help you decide if it is a good fit for your financial picture.

What is a HELOC and how does it work?

A home equity line of credit (HELOC) is a revolving line of credit secured by your home. It works in two phases: a draw period, during which you borrow, repay, and borrow again up to your credit limit, and a repayment period, during which you pay back the remaining balance. Repayment periods typically range from 10 to 20 years depending on your lender and the term you choose.

Most HELOCs have variable interest rates, which means your payment could change over time as rates change. It’s possible to find a fixed-rate HELOC with an interest rate that’s set on day one and never changes. Because a HELOC is guaranteed by your home, lenders may offer lower rates than they do on unsecured loans like most credit cards and personal loans.

Pros of a HELOC

HELOCs offer several potential advantages.

Lower interest rates. A HELOC is secured by your home. That’s a financial safety net for the lender. In a worst-case scenario, if you don’t repay the loan, the lender could sell your home to recover the money you owe. Because of this extra layer of protection against loss, lenders typically offer lower interest rates on HELOCs compared to loans that don’t have the same kind of safety net, like most credit cards and personal loans. For borrowers carrying high-interest debt, consolidating to a loan with a lower rate could reduce total interest costs.

Interest on what you use. You only pay interest on the amount you owe, even if that’s not your full credit limit.

Flexibility. A HELOC could be used for a range of purposes, including home improvements, debt consolidation, medical costs, and education expenses.

Possible tax advantage. If you use the funds for home improvements on the property you borrowed against, the interest may be tax-deductible. Talk to a tax advisor about what applies to your situation.

Cons of a HELOC

Every loan deserves careful consideration. Here are the key factors to weigh with a HELOC.

Variable rate risk. Most HELOCs carry variable interest rates, so your payment could change if rates rise. Opt for a fixed-rate HELOC if you don’t want to worry about your interest rate fluctuating over time.

Collateral. Your home is the collateral. If you don’t repay the loan, you could lose your home.

Payments could spike at repayment. Some lenders allow you to make interest-only payments during the draw period. If you do this, the balance you owe won’t go down, even if you make payments for years. Also, when your repayment period begins, you’ll start making a principal-plus-interest payment, which could be sharply higher than the interest-only payment you were making.

When is a HELOC a good idea?

A HELOC could be a good choice when you have enough equity in your home, stable income, and a repayment plan in place. Two of the most common situations where a HELOC may make sense include the following.

Enough equity in your home. Home equity is the difference between what you owe on your mortgage and how much the home is worth. You’ll need to have enough equity to borrow against and still stay under your lender’s loan-to-value limit.

Varying draw needs. If a line of credit is better aligned with your needs than a one-time lump sum loan, a HELOC is a good fit.

HELOC vs. other ways to borrow against home equity

A HELOC is one of several ways to access home equity. Here is a comparison of the three most common options.

Questions to ask yourself before applying for a HELOC

Work through a few honest questions before you apply to help you borrow with more confidence and a clearer plan.

1. How much equity do I have? Most lenders require that you still have at least 15-20% equity after the HELOC is in place. That means your mortgage plus your HELOC can’t equal more than 80-85% of your home’s current market value. A debt-to-income ratio calculator and a debt payoff calculator could help you think through the numbers before you apply.

2. What’s the reason I want to borrow? Is your goal to optimize your existing debt or improve your home? Those are good ideas for how to use a HELOC. On the other hand, a HELOC typically isn’t advisable for luxuries that you can’t afford right now, such as travel.

3. How long do I plan to stay in my home? A HELOC typically makes more sense if you plan to remain in your home for several years. As with most mortgages, there are usually fees associated with getting a HELOC, so you’ll want to get your money’s worth on the loan.

What you need to apply for a HELOC

Most lenders consider the following when reviewing a HELOC application.

• Home equity. At least 15-25% remaining equity after the HELOC is factored in.

• Credit score. A credit score of 600 to 670. A higher credit score generally improves your options.

• Stable, verifiable income. Lenders will verify that you can afford the payments.

• Debt-to-income ratio. Debt-to-income ratio, or DTI, is your monthly debt payments compared to your monthly before-tax income. Most lenders set the cutoff between 43% and 50%.

• Home appraisal. Your lender will verify your home’s current market value. 

It’s easy to find out if you prequalify for a HELOC, and only takes a few minutes.