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.
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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.
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.)
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.
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.)