Home Equity Line of Credit: An Underrated, Yet Powerful Financial Tool

When we started working with a financial advisor a few years ago, very few things surprised me.

Since we’d already created a financial plan without an advisor, I had my savings goals and plan of attack, and everything was feasible given our financial situation.

But we had holes in our system because I didn’t have a complete picture of what we needed. The best example was our estate plan – we didn’t have one! In the years since our first few meetings, it’s something we’ve checked off our list.

Another example of this was opening a home equity line of credit for financial flexibility. I had no reason to get one – I wasn’t consolidating debt or planning a significant home improvement, so I never considered it.

So when our advisor suggested a HELOC – I wondered why?

It was to have access to the credit even if there’s no immediate need. If one appears, it’s there, and you don’t have to go through the process.

What is a Home Equity Line of Credit?

A home equity line of credit (HELOC) is a line of credit where the collateral is the equity in your house. It’s not a loan, and you don’t get a lump sum, and you have access to this line of credit.

A few terms to know when it comes to HELOCs:

• Draw period: How long the line of credit is available – so if you have a 10-year draw period, you can draw on the LOC over ten years. You only pay interest on what you borrow during the draw period – you don’t have to pay down the principal. If you do, you get access to that credit again.
• Repayment period: Comes after the draw period. You can’t borrow anymore, and the HELOC becomes like a regular loan. The interest rate is fixed.

Our advisor recommended it because it gives you additional financial flexibility if you need a large sum. Many people use it to consolidate debt because of the low rates, make home improvements, pay medical bills, or receive an education.

What separates a HELOC from a loan is that you only pay interest on your borrowed sum. If you have a $10,000 HELOC but borrow none of it, you pay no interest.

A HELOC isn’t free, though – it’s like getting access to a loan without fees. Many banks do not charge a closing cost fee, and that’s huge.

Unless prohibited by law, there is an annual fee and an early termination fee if you close it within a certain number of months (like 36 months). All banks will charge this fee, and it varies but usually around $50-$75 for the annual fee and $400-500 for the early termination fee.

Qualifying for a HELOC

The most challenging hurdle can be having sufficient home equity.

It would be best to have at least 15-20% equity. As a basic rule of thumb, you have enough equity if you’re no longer paying private mortgage insurance premiums (PMI).

Some of the other minimum HELOC requirements include:

• Credit score: Usually 620 or above, just like a private mortgage
• Debt-to-income ratio (DTI): 43% or lower
• Reliable income: Be ready to show recent pay stubs or your latest tax return
• Mortgage servicer approval: Your current servicer must approve your HELOC request if you still have a mortgage. Your HELOC classifies as a second mortgage in this situation.

The underwriting process is similar but not as rigorous as a conventional mortgage.

For example, your lender will most likely only perform a “desktop appraisal” instead of requiring an on-site home inspection such as applying for a mortgage or cash-out refinance.

As a result, your HELOC application process in as little as 14-28 days vs. 60 days for a mortgage.  

HELOC vs. Home Equity Loan

While a HELOC and a home equity loan can help tap your available equity, several differences exist.

A HELOC lets you make multiple withdrawals over your draw period. There are minimal withdrawal restrictions, so you can use the cash to consolidate high-interest debt, buy an investment property, start a business, go on vacation (which I don’t recommend borrowing for), etc.

Home equity loans provide a lump-sum distribution of your cash, and you can only use the funds to improve or repair the residence that secures the loan. 

Unlike HELOCs, this loan has a fixed interest rate. Variable rates can make it difficult to predict your total interest costs if your rate adjusts higher.

HELOC Pros and Cons

Here are some of the advantages and disadvantages of using a HELOC to borrow money. 

Pros

• Flexible withdrawal requirements: You can use your funds for legal purposes. 
• Multiple withdrawals: Making unlimited withdrawals during your draw period can minimize your total interest costs versus an upfront lump sum.
• Minimal fees: This financing option can charge fewer application fees than a cash-out refinance or a personal loan.
• It doesn’t impact your existing mortgage: A HELOC is a second mortgage if you still have a house payment, and it won’t modify your current interest rate or repayment term like a cash-out mortgage refinance.

Cons

• Variable interest rate: Most HELOCs have a variable interest rate during the draw period. Variable APRs tend to be initially lower than fixed APR loans. However, your future rates are more likely to be higher in a rising interest rate environment like we’re currently experiencing.
• Your home is collateral: Defaulting on this loan can result in foreclosure on your residence securing the loan. 
• Interest may not be tax-deductible: HELOC interest is only tax-deductible when the funds “are used to buy, build or substantially improve the taxpayer’s home that secures the loan,” says the IRS.
• Interest-only payments: You’re only required to make interest-only payments during the draw period. This low cost is convenient if funds are tight or you want to use your capital for productive assets. However, paying off the balance during the repayment period can be challenging. 

How Not to Use a Home Equity Line of Credit

A HELOC is an excellent way to quickly acquire a large sum of cash with a low interest rate. For example, you may need to make a cash offer on investment property, and getting a purchase loan means losing the bid to another investor.

It can also be an effective way of getting rid of credit card debt at a lower cost. While the bank can’t control how you use your line of credit, here are some situations to avoid.

Using It as a Personal ATM

Your HELOC shouldn’t be the first bank account you pull from if you struggle to pay your monthly bills. It’s also not a substitute for a brand-new credit card to go on a shopping spree or pay for a luxury vacation that you can’t afford. This practice can morph into a debt problem that’s difficult to exit.

Instead, look for ways to trim your spending or boost your income to live within your means. This practice also keeps your HELOC open for purchasing income-producing assets or consolidating high-interest debt. These two goals can improve your financial situation. 

Improperly Using Revolving Credit

A HELOC is a revolving credit account similar to a credit card. Your bank reports your monthly balance and payment history to the credit bureaus.

A higher balance can hurt your credit score and make it harder to qualify for new credit. 

Unlike an installment loan with fixed monthly payments (i.e., a home equity loan or a personal loan), the loose repayment schedule can be challenging for some to calculate their principal balance payment during the draw period. 

Mixing Tax-Deductible and Non-Deductible Expenses

Using your credit line for tax-deductible home improvements and ineligible expenses can make it difficult to estimate your qualified interest payments. 

Is a Home Equity Line of Credit Right for Me?

Here are a few reasons to consider a Home Equity Line of Credit:

• You don’t need an upfront lump-sum distribution
• Want the ability to make on-demand withdrawals for up to 10 years
• Comfortable using your home as collateral
• Can responsibly manage revolving credit
• Can afford a variable interest rate and potential rate hikes

The best uses of a home equity line of credit are to pay off high-interest debt, perform home improvements, and obtain expensive investments.

You should avoid this financial tool if it encourages you to live beyond your means. Examples include an expensive vacation, buying a vehicle above your price range, or purchasing big-ticket home entertainment items that aren’t exactly a “substantial home improvement.”  

If you decide to apply for a HELOC, remember to compare rates and fees from several lenders. The differences between banks can be eye-opening.

HELOC Alternatives

It’s hard to compete with the low interest rates and flexible repayment terms. However, these loan types can be a better fit for your borrowing purposes or if you don’t have enough available equity.

Home Equity Loan

Consider a home equity loan if you’re only using the funds for home improvement projects and need a lump sum. You can qualify for a similar interest rate and have a longer repayment term.

In addition, you have a fixed monthly payment which makes planning your monthly budget easier.

Personal Loan

An unsecured personal loan has similar spending flexibility as you can use your loan proceeds for almost any expense. 

Your borrowing limit can be less, but your home isn’t put up for collateral. You can also have a fixed interest rate with a 3-year or 5-year repayment term. 

Auto Loan

If you’re thinking about using a HELOC to buy a car, apply for a car loan to avoid losing your house. The interest rate can be competitive as your vehicle serves as collateral, and you have a fixed monthly payment.

0% APR Credit Cards

A 0% balance transfer credit card may be better for small balances. The interest-free period is 12-18 months for most cards.

Expect to pay a one-time balance transfer fee (approximately 3%) on the transfer, but you can avoid interest charges. This fee can be less than your HELOC interest and origination fees. These cards usually extend the 0% introductory APR to new purchases.

I should point out that cash back credit cards usually offer the best 0% APR offers.

Final Thoughts

Your HELOC is one of the cheapest and easiest ways to maximize your spending power and improve your financial situation. It’s easy to open an account even if you’re not ready to borrow money at the moment but might soon. This way, you will be in a position when the right opportunity lands, and you can avoid the hassle of the traditional loan process.