If you have more than 20% equity in your home, you may qualify for a home equity line of credit, or HELOC. A HELOC is a convenient and often inexpensive way to borrow money. You don't have to get a HELOC from the company that services your mortgage, you can shop around with a number of lenders. Let's look at how a HELOC works and whether its unique features might make it a good or bad option for you.

TUTORIAL: Exploring Real Estate Investments

How Do HELOCs Work?
If you understand how credit cards work, you already have a basic understanding of how HELOCs work. With a credit card, the bank establishes a credit limit based on your household income and credit score. Each billing cycle, you can spend as much or as little as you want, as long as you stay under that limit. When you pay your bill, your available credit increases by the amount of your payment. A HELOC works similarly, but your credit limit is based on how much equity you have in your home. (For related reading, see Home-Equity Loans: What You Need To Know.)

HELOCs: Key Features
While the basic concept of a HELOC resembles the basic concept of a credit card, there are a number of important differences between a HELOC and a credit card. Borrowers should thoroughly understand these features before applying for a HELOC.

Underwriting Standards
HELOCs are subject to underwriting standards, which means that you'll need to document your income and employment status like you would if you were refinancing your home. When you apply for a credit card, you are asked to provide information about your income and employment, but you don't have to document it. Not all borrowers will qualify for a HELOC. Qualifying for a credit card may be easier.

Since a HELOC is secured by your home equity, if you don't repay it, you could end up in foreclosure. A credit card is a form of unsecured credit, so you're significantly less likely to lose your home if you can't repay what you borrow. With credit card default, even if your creditors sued you, and you had to declare bankruptcy, you might be able to keep your home. (For related reading, see The Pitfalls Of Buying A Foreclosure Home.)

Interest Rates
HELOCs, like most credit cards, have variable interest rates. With a credit card, your interest rate is based on a benchmark interest rate like the prime rate or London Interbank Offered Rate (LIBOR), plus a margin that's based on your credit score, repayment history and how much the lender needs to charge to potentially earn a profit. HELOC interest rates are based on similar factors. However, HELOCs often have significantly lower interest rates than credit cards. That being said, when interest rates increase, people who thought they were borrowing money cheaply could find themselves stuck with large and expensive HELOCs with interest rates comparable to credit card rates.

Interest Deductibility
Unlike credit card interest, HELOC interest is tax deductible unless you are subject to the alternative minimum tax or take the standard deduction instead of itemizing. This feature can make HELOCs cheaper than credit cards in any interest-rate environment, but it can also get borrowers into trouble.

High-Interest Debt Refinancing
If the interest rate on a HELOC is 5.5% and the interest payments are tax deductible, and the interest rate on your credit card debt is 29.9% and the interest payments are not tax-deductible, it's easy to see how a HELOC can save you a ton of money and help you get out of debt faster. However, some people will use a lower-interest HELOC to pay off higher-interest debt, then use their newly replenished credit card limits to accumulate more debt.

Will a HELOC Help You or Hurt You?

If you want to borrow against the equity in your home using a HELOC, make sure you understand how they work. In particular, you need to know when and by how much your interest rate might change before you borrow. Will you be able to afford the monthly payments if they go up later? How much of an increase can you stomach? Will the things you want to purchase with your HELOC money still be worth it at a higher interest rate?

The Bottom Line
You should also think about how you plan to use the money and your past borrowing behavior to decide whether a HELOC is likely to help or hurt your finances in the long run. If you have a habit of abusing credit and don't trust yourself to change your ways, you may be better off leaving your home equity intact and keeping your debt on your credit cards. (For related reading, see Protect Yourself From HELOC Fraud.)

Related Articles
  1. Insurance

    What is a Force Majeure?

    A force majeure clause frees both parties in a contract from fulfilling their obligations in the event of some catastrophic or unexpected occurrence.
  2. Credit & Loans

    Explaining Equated Monthly Installments

    An equated monthly installment is a fixed payment a borrower makes to a lender on the same date of each month.
  3. Investing Basics

    Tiny House Movement: Making Market Opportunities

    The tiny house movement throws all assumptions about household budgeting and mortgage management out the window, and creates new market segments too.
  4. Investing

    Where Should I Keep My Down Payment Savings?

    While saving up for a down payment, where should you keep your money. A bank? The stock market? It all depends on your timeline.
  5. Credit & Loans

    Questions To Ask Your Mortgage Lender

    When buying a house, avoid nasty surprises by asking the right questions about your mortgage lender's qualifications and the mortgage process.
  6. Home & Auto

    The Most Expensive Neighborhoods in Manhattan

    Understand why Manhattan has some of the priciest residential real estate in the world. Learn about the top four most expensive neighborhoods in Manhattan.
  7. Home & Auto

    The Most Expensive Neighborhoods in Los Angeles

    Understand the layout of the greater Los Angeles area and what is driving up home values. Learn about the top eight most expensive places to live in LA.
  8. Personal Finance

    Should You Renovate or Move?

    Besides cost, what factors should you consider in deciding whether to remodel your home or move? This tutorial guides you through the steps.
  9. Home & Auto

    4 Home Upgrades That Don’t Pay

    Many remodeling projects sound good in theory, but don’t recoup their costs when it’s time to sell the house.
  10. Credit & Loans

    Bad Credit? You Can Still Get a Home Equity Loan

    If your credit history is less than stellar and you need cash, you may be able to get financing – but it will come at a price.
  1. What are some examples of good situations in which to use revolving credit?

    There are two main ways in which you can be granted credit: installment credit and revolving credit. Revolving credit accounts ... Read Full Answer >>
  2. What are some examples of a good time to take out a home equity line of credit (HELOC)?

    A home equity line of credit is a loan product that allows you to use funds from an account as needed, up to a specified ... Read Full Answer >>
  3. How do I calculate how much home equity I have?

    Even though it is normally assumed most people know their home equity, many are still confused about the topic. It is an ... Read Full Answer >>
  4. What is the difference between "closed end credit" and a "line of credit?"

    Depending on the need, an individual or business may take out a form of credit that is either open- or closed-ended. While ... Read Full Answer >>
  5. In what instances does a business use closed end credit?

    The most common types of closed-end credit used by both businesses and individuals are mortgages and auto loans. Businesses ... Read Full Answer >>
  6. What are the typical requirements to qualify for closed end credit?

    Typical requirements for a consumer to qualify for closed-end credit include satisfactory income level and credit history, ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!