A home equity line of credit (HELOC) seems like a great way to exchange equity in your home for cash you can use for a variety of needs.[cite::219::cite] But, it’s best to understand all the implications of and alternatives before you apply for a HELOC.
What is a HELOC and How Does It Work?
A home equity line of credit, or HELOC, is a revolving line of credit that’s based on your home’s equity. Your home equity is your residence’s value minus how much you owe any mortgage on your property. Basically, it's the amount of your home's value you own from the principal in the mortgage payments you've already made.
These loans work like credit cards, with set credit limits that enable you to borrow money, make monthly payments, and borrow again, as you need. Typically, you’ll get a card or checks for borrowing available funds up to the credit limit.
When borrowing begins, you’ll make minimum payments monthly, and usually, you pay interest only on the money borrowed. Your interest rate may be a predetermined variable one that’s low because your house is the loan’s collateral. But, your rate can spike between months.
You're allowed to withdraw any amount during your "draw period", often five or ten years, after which repayment begins, and you won't be able to borrow additional money.
In repayment, your HELOC resets, your payment gets much higher since you’re paying both interest and principal monthly, and your APR may rise. That’s if you don’t have an immediate balloon payment due.
What Are the Best Ways to Use a HELOC?
You can use a home equity line of credit for any purpose you like, but the best ways to use HELOCs are smart investments like:
Home improvement projects that increase your home’s value Remodeling your home to accommodate family changes
Educational costs like college or graduate school tuition
Financing a business revenue gap
Start by deciding your HELOC’s purpose. You must be certain that using it in that way won't be financially straining, and limit your borrowing to remain in financial control if and when interest rates go up.
What Are Poor Uses of a Home Equity Line of Credit?
Your house is collateral for your HELOC, and you don’t want to jeopardize your home by misusing this typically large loan. These purposes aren’t ideal for HELOCs: Debt consolidation
Ongoing emergency fund
Extravagant or luxury purchases like a new car or vacation These uses are risky if you can’t repay the funds back immediately, and you’ll be repaying the loan longer than you had these needs. You want to make sure you use your HELOC as an investment that will gain more value than you pay in interest.
Alternatives to a HELOC
It’s better to use a credit card or take a personal line of credit for smaller projects, expenses, and other similar uses for which HELOCs aren't suited. These are forms of unsecured debt that won’t cost you your home if you don’t repay.
Also, saving up money over time for emergency funds and discretionary expenses like vacations and cars is always better than going farther into debt.
How to Apply for a HELOC
The process is similar to applying for any mortgage loan. Here are several steps:
- Check your credit. Pull your credit reports, and make sure they’re in good shape.
- Know your FICO score, since it will help determine your loan eligibility and interest rate.
- Review your debt and income. Lenders will use your debt-to-income ratio to decide how much you can borrow and your ability to repay.
- Determine your home’s equity. If you don’t have sufficient equity, you won’t qualify for a HELOC. Research finding a home's appraised value to know before contacting lenders.
- Shop around. Contact different lenders about rates, fees, special terms, and requirements, since they can vary widely. Be careful of too-good-to-be-true teaser rates or scams.
- Get your paperwork in order. Gather all the documents you’ll need to apply for your HELOC, so you don’t delay the process.
Armed with information on the pros and cons of a home equity line of credit, decide if it fits your financial picture before applying. Use a HELOC smartly, and it can be a wise way to get funds for strong investments that will more than pay for themselves over time.