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.

Table of Contents
  1. What is a Home Equity Line of Credit?
  2. Qualifying for a HELOC
  3. HELOC vs. Home Equity Loan
  4. HELOC Pros and Cons
    1. Pros
    2. Cons
  5. How Not to Use a Home Equity Line of Credit
    1. Using It as a Personal ATM
    2. Improperly Using Revolving Credit
    3. Mixing Tax-Deductible and Non-Deductible Expenses
  6. Is a Home Equity Line of Credit Right for Me?
  7. HELOC Alternatives
    1. Home Equity Loan
    2. Personal Loan
    3. Auto Loan
    4. 0% APR Credit Cards
  8. Final Thoughts

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.

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About Jim Wang

Jim Wang is a forty-something father of four who is a frequent contributor to Forbes and Vanguard's Blog. He has also been fortunate to have appeared in the New York Times, Baltimore Sun, Entrepreneur, and Marketplace Money.

Jim has a B.S. in Computer Science and Economics from Carnegie Mellon University, an M.S. in Information Technology - Software Engineering from Carnegie Mellon University, as well as a Masters in Business Administration from Johns Hopkins University. His approach to personal finance is that of an engineer, breaking down complex subjects into bite-sized easily understood concepts that you can use in your daily life.

One of his favorite tools (here's my treasure chest of tools,, everything I use) is Personal Capital, which enables him to manage his finances in just 15-minutes each month. They also offer financial planning, such as a Retirement Planning Tool that can tell you if you're on track to retire when you want. It's free.

He is also diversifying his investment portfolio by adding a little bit of real estate. But not rental homes, because he doesn't want a second job, it's diversified small investments in a few commercial properties and farms in Illinois, Louisiana, and California through AcreTrader.

Recently, he's invested in a few pieces of art on Masterworks too.

>> Read more articles by Jim

Opinions expressed here are the author's alone, not those of any bank or financial institution. This content has not been reviewed, approved or otherwise endorsed by any of these entities.

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  1. Carla says

    Went to Capital One site and even with excellent credit it came back at over 6% rate. That is like bait and switch to me. Advertises 3.20 and then comes back that high. Crazy. I am in Maryland as well. Are all banks/lenders going to be like that?

    • Jim Wang says

      Excellent question – we all know that every time a rate is advertised it’ll be the rock bottom rate. So all banks will say their lowest possible number and who knows who qualifies that that.

      When I played with it I was told it’d be somewhere in the 4.5% range for both a 30 and 20 year line of credit and I have excellent credit too. Perhaps it was loan amount? Some other LOC related factor?

  2. MICHAEL HAWKESWORTH says

    Jim,
    I appreciate your efforts to educate our populace in financial wisdom and responsibility. It has not gone unnoticed by me since signing up for your information.

    That said my recent reading (last 6-8 months) about HELOCS and their affect on banks and borrowers indicates more problems than advantages for both bank and borrower. The banks can’t sell the loans and the borrowers didn’t budget for the increase in their household payments. Of course the responsibility in creating personal debt is on the borrower.

    These HELOCS could prove to be a disadvantage if these home values which have risen back to just below peak values in most cities crater again as in 2009.

    Again personal responsibility it key!

    Regards,

    Michael

    *disclaimer: built a net worth of 12 million dollars between 1998-2015 on 2500.00 cash and real estate debt. Have been debt free since 2007.

    • Jim Wang says

      Hi Michael – I’m not concerned about the affect on the banks, that’s for their underwriters to worry about. As for borrowers, those concerns would exist for any type of loan. If you don’t budget for the increase in household payments because you utilized the cred line, you’re a fool. It’s not limited to HELOCs.

      As for a disadvantage if home values fall, how does it impact the borrower if the value falls? The line still exists and the flexibility is there. Falling home values would be a negative if you are going to sell, or if you were trying to get another or increase a line, but otherwise it’s unimportant.

  3. MICHAEL HAWKESWORTH says

    While I agree with all you said I will just add this:

    1. The banks got bailed out with OUR money.

    2. Most of our populace are fools in my opinion.

    Appreciate your efforts to educate.

    Regards,

    Michael

    • Jim Wang says

      1. Yes, but those programs ended up being profitable (though not the intent going into them). And the banks didn’t have issues because of HELOCs, it was all CDOs and derivative products that were marketed as safe but ultimately filled with hot trash.

      2. Again, nothing to do with HELOCs. 🙂

  4. Jim Astor says

    I have two HELOCs from Pentagon Federal Credit Union and am quite pleased with the rate and terms. There are no fees. We used the first line to do some home improvements, and then kept the line open for any emergencies or special needs. The second line was to help my son fund his business start-up as the banks refused to take the huge “risk”. My son is paying off the credit line at an accelerated pace and I’m confident he will be able to obtain future financing from Pentagon FCU. Banks have proven themselves to be only interested in lending to well established companies with little or no risk, while charging their other clientele outrageous fees for poor services and products. Credit Unions are the way to go.

    • Jim Wang says

      That’s a fascinating idea I’d never considered, by having a HELOC you add another player in any legal proceedings. I’d never considered it before but I like the idea (if it works).

  5. Lazy Man and Money says

    I had a HELOC back in 2006, but around 2008-2009, it went away for reasons we’ll never know ;-).

    About 18 months ago, we got another one. The main purpose was to finance solar panels, one of those rare home improvement projects that seem to greatly pay off in the long term… at least in some states.

    It had no annual fee and at a 2.99% rate. As we started to pay it off, I realized that it can function as part of an emergency fund. It certainly isn’t a replacement for having access to cash. However, rather than keeping $50,000 in cash, maybe people would be comfortable with $25,000 in cash and $25,000 of a HELOC to tap into. This frees up another $25,000 for investing at higher rates. Since you only pay the small interest rate if you need it, most of the time it just sits there as an insurance policy.

    • Jim Wang says

      Yeah, so my next post on HELOCs will actually cover emergency funds, so you’re ahead of the game. 🙂

      My thinking is that rather than 50k cash you can do 25k cash and 25k HELOC, but that HELOC is backed up with 25k invested. You probably won’t need 50k all at once and so you give yourself time to get the invested $25k out (in an orderly fashion) if necessary using the HELOC as a buffer.

      • Lazy Man and Money says

        Indeed. If you don’t need that invested 25K for 7-10 years and it doubles, you have the 25K in cash, a 50K investment to tap into, and the HELOC you had before. I’d call that a fundamentally stronger emergency fund.

        Then you start to layer in the ability to withdraw Roth IRA contributions penalty-free. Obviously it isn’t ideal, but no emergencies are.

        I bet there are a number of people with “hidden” emergency funds with potentially $100K that could be tapped who don’t realize it.

        • Jim Wang says

          Ha for sure, and the only cost is the $50 or so a year you pay on the HELOC.

          A lot of times when I look at our net worth, I also calculate a “liquid net worth” that I view as the “what if I had to liquidate everything right now” — that’s ultimately the “shit hit the fan” emergency fund.

  6. Shaun says

    I’ve had a HELOC on my property for over a decade now. It can make a good emergency fund and rates are almost always lower than credit card rates. As with any debt, it’s important not to borrow more than you can handle. I have also used funds from my HELOC for a type of arbitrage – borrow against the HELOC at 4.5%, invest at 8%. Free money! (Assuming you can find a safe investment returning 8%, which I did.) But I am really puzzled by the yearly fee on your HELOC. I’ve never had one that charged a yearly fee. Granted, all mya HELOCs have been from brick and mortar banks, so I wonder if your yearly fee is basically a yearly payment for the convenience of opening a HELOC online.

  7. Wallace Wong says

    Great articles and comments! These hacks are awesome! I’ve used the HELOC strategy for years now and it’s been working for me. I’ve learned other bank related hacks that I can share… did you know that there are other lines of credit (LOC) out there not tied to your home? A home is just the collateral the bank requires when lending money. I’ve gotten LOCs on cash value in my life insurance policy, stocks, and even CDs. The smaller regional and local banks can do this. You just have to ask. Why do this? Your money is working more efficiently.

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