Residential real estate values continue to rise, meaning your home can be a valuable source of wealth. One of the most common ways is to take out a Home Equity Line of Credit (HELOC), which is like a giant credit card, allowing you to borrow from your ownership (equity) as needed over a set period of time and pay it off over decades. If you own a significant portion of your home, you could potentially qualify for a five- or even six-figure amount — much more than you could borrow with a personal loan.
HELOCs have many benefits. But they also come with risks. You have to use your home as collateral, and you pay a variable rate of interest, which means interest rates could rise and your payments could increase significantly.
Let’s take a look at all the pros and cons of a HELOC.
Summary: What are the pros and cons of a HELOC?
Strong Points
- Low interest rates
- Flexibility
- Tax-deductible interest
- Potential for improved creditworthiness
Cons
- Variable interest rate/payment
- The house is in danger
- Diminishing capital cushion
- Your balance may disappear quickly
Benefits of mortgage secured loans
Low interest rates
While mortgage rates across the board have increased significantly since 2022, HELOC interest rates still tend to be lower than credit card and personal loan rates. If you qualify for the best rates, a HELOC can be a cheaper way to consolidate debt or fund home improvements.
Flexible terms
With a HELOC, you use the funds as needed and pay back only what you borrowed (with interest). If you need less cash than you thought, your payments will be lower. In contrast, a home equity loan or personal loan requires you to pay the full amount back in one lump sum (with interest) whether you use all of the funds or not.
Most home equity loan providers also offer flexibility when it comes to how you access your HELOC funds, whether that be by debit card, check, ATM, online transfer, etc. Additionally, some will let you convert all or a portion of your HELOC balance into a fixed-rate loan, so you don’t risk being charged a higher interest rate later.
Another point of flexibility is repayment. Many lenders also offer interest-only HELOCs, where you only pay interest and not principal during the drawdown period (usually 10 years). This makes payments more manageable. Of course, you can always choose to repay all or part of the principal, which will restore your credit limit.
Potential tax deductions
Even after the Tax Cuts and Jobs Act of 2017, you can still deduct interest if you use HELOC funds for home improvements. Specifically, the IRS allows you to deduct interest if you use HELOC funds to “purchase, build, or substantially renovate a home.” However, the deduction is only available up to certain limits based on the total amount of mortgage debt. You must itemize your deductions to take advantage of this deduction.
Potential for improved creditworthiness
Two of the most important components of your credit score are your payment history and your credit mix. Adding a HELOC to your history and making payments on time can help raise your score. (But keep in mind that using a HELOC to change your credit utilization ratio could also lower your score.)
High loan limits
HELOCs are for large amounts — at least five figures. The smallest credit limit you can get is often $10,000, and many lenders will require you to make an initial withdrawal of at least that amount.
The benchmark interest rate for a HELOC tracked by Bankrate is $30,000, and some lenders offer lines of credit of $750,000 or even $1 million.
However, the size of your line of credit will depend on your home’s equity, or the percentage of the equity you own. Generally, you can borrow up to 80 percent of your property’s value, but depending on the lender and your financial situation, you may be able to borrow up to 90 percent.
But your mortgage balance also affects how much equity you have available. When a lender says you can borrow up to 80%, they mean the total amount. all Your home-related debt (your current mortgage plus your new HELOC combined) can’t exceed 80 percent of your home’s value — in financial jargon, this is called your combined loan-to-value ratio (CLTV).
For example, let’s say your home is worth $425,000 and your mortgage balance is $250,000. That means your property is worth $175,000 and your loan-to-value ratio (LTV) is 59 percent ($250,000 / $425,000 * 100). Lenders will allow you to borrow up to 80 percent of the property’s value. This means that if your lender approves your HELOC, your maximum credit limit is $90,000 ($425,000 * 0.80 – $250,000).
Disadvantages of mortgage-backed financing
Prices vary
While the interest rate on a home equity loan is fixed, the interest rate on a HELOC is variable. This means that interest rates can go up or down depending on economic conditions, the Federal Reserve’s monetary policy, and other factors, which affects the amount you pay back. Even if you get a low interest rate on a HELOC, your interest rate could be much higher when you pay it back.
“Adjustable interest rates can turn your payments into a financial roller coaster,” says Linda Bell, senior mortgage specialist at Bankrate. “What may have started out as an amount you can manage can quickly turn into unmanageable debt that puts your home at risk.”
The house is in danger
A HELOC is a secured loan, which means it’s backed by collateral — your home, specifically. Secured loans tend to have lower interest rates, but using your home as collateral means they carry more risk. “Because you’re borrowing against your home, you’re at risk of foreclosure if you don’t make your monthly payments,” concludes Sean Murphy, vice president of mortgage operations at Navy Federal Credit Union.
Diminishing capital cushion
When you borrow through a HELOC, you’re borrowing against the equity in your home. If home and real estate values fall, you could end up owing more than your home is worth. Plus, if your home is your largest asset, using your HELOC to secure your home reduces your net worth, which could limit your ability to borrow more.
Your balance may disappear quickly
Many HELOCs allow for interest-only payments during the drawdown period, making it easy to access cash without thinking about the financial consequences. “If the borrower doesn’t repay funds into this line of credit, the loan will eventually begin to amortize, resulting in a significant increase in payments,” says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego. In short, if you don’t anticipate/budget for a spike in your monthly payments, you could be in for an unpleasant surprise at the start of the repayment period.
Additional Costs and Fees
HELOCs generally have lower closing costs than home equity loans (you don’t need as many common expenses, like title insurance). But be careful of other fees that can add up quickly. In most cases, you’ll have to pay a fee to open the line of credit and an annual fee to maintain that line. Lenders may charge a fee to freeze the interest rate on some of your withdrawals. They may also charge penalties for early withdrawals, inactivity fees if you don’t withdraw funds frequently, and fees each time you make a withdrawal, although the amounts vary by lender.
“This highlights the importance of negotiating with lenders and comparing fees,” Bell says. “Some of the costs aren’t fixed, and because lenders want your business, you may be able to negotiate some of them down before you sign the contract.”
Should I get a HELOC?
HELOCs are great when you need access to cash for an extended period of time, especially when you’re not sure how much you’ll need, such as a multi-stage home renovation that will span months or years. They can also be used for more specific expenses that occur periodically over time, like a child’s college tuition or ongoing medical treatments.
If you’re looking to use it as needed and pay back only what you borrow, a HELOC may be a better option than a lump-sum home equity loan, Murphy says.
It’s not a good idea to open a HELOC for entirely discretionary expenses like vacations, weddings/honeymoons, or big-ticket items like cars, furniture, or appliances that depreciate in value. Using a HELOC to pay off credit card and other high-interest debt is possible, but controversial; a home equity loan (see below) may work better. A HELOC can serve as a short-term emergency fund, but shouldn’t be used as an ongoing supplement to your household finances. Using a HELOC for everyday expenses will only put you further in debt.
But HELOCs do come with risks. Variable interest rates can rise, and if you can’t repay the loan for any reason, you could lose your home. Plus, you could be lulled into a false sense of funds during the drawdown period, only to be brought back to reality once the repayment period begins.
Possible prepayment or early termination penalties
Some lenders charge a fee if you pay off and close a HELOC during the drawdown period or shortly before the repayment period. This penalty can be a problem if you want to pay off the debt right away instead of over 10 to 20 years. You could also be penalized if you plan to sell your home soon, since you’ll have to pay off the balance in full when the home changes hands.
HELOC Alternatives
If you don’t think a HELOC is right for you, consider these loan alternatives.
- Mortgage: A home equity loan is similar to a HELOC, but it gives you a lump sum of cash instead of a line of credit. Repayments begin immediately at a fixed interest rate, so your monthly payments don’t change. If you know exactly how much you need up front and plan to use it up quickly, a home equity loan may be a better option than a HELOC.
- Cash-out refinance: A cash-out refinance replaces your existing mortgage with a new loan that has a larger balance. You can take the difference in cash, based on your home’s equity (many lenders allow you to borrow up to 80 percent of the home’s value). Generally, a cash-out refinance is only a good idea if you can get a lower interest rate, can afford the closing costs, and plan to stay in your home for a long time.
- Personal Loans: Like a mortgage, a personal loan comes with fixed monthly payments, a fixed interest rate, and a lump sum upfront payment. The big difference between these loans and a HELOC is that personal loans are unsecured, so you don’t have to put up your home or other assets as collateral. However, they tend to have higher interest rates than a HELOC, and you may not be able to borrow as much money.
Summary of HELOC Pros and Cons
A home equity line of credit (HELOC) is an option for disciplined borrowers who want to tap into the inherent equity in their home. Compared to other home equity products, a HELOC offers the most flexibility in terms of how much you can borrow and when you pay it off. The structure of a HELOC allows you to make low monthly payments and avoid unnecessary debt and interest.
But HELOCs also have variable interest rates, meaning you could end up paying much more in interest than you expected, and the seemingly unlimited line of credit could be risky for less disciplined borrowers.
When considering a HELOC, think honestly about your financial habits, potential risks, and the nature of your financial needs. HELOCs are best when you need a fixed amount or funds over a long period of time. And the money should go toward improving your home or your financial situation.
