Pros and cons of a home equity line of credit (HELOC)

Please note: Discover® Home Loans offers a home equity loan product, but does not offer HELOCs.

Home equity lines of credit (HELOCs) offer a way to tap into the equity in your home and provide you with some flexibility in how you withdraw funds. While a HELOC might not be the best option for every homeowner looking to pull cash from their home, it’s an option worth considering.

Key points of a HELOC

• A HELOC is a second mortgage that helps you turn your home equity into cash.
• Cash from a HELOC can be used for pretty much anything — from funding home renovations to consolidating debt to emergency expenses.
• HELOCs are revolving lines of credit, so you can borrow funds as you need them. However, they often come with variable interest rates.

Many homeowners might not know how a HELOC works, and those that do know still might not be certain whether a HELOC is exactly what they want to apply for.

By learning more about HELOCs and comparing the pros and cons, you can decide whether a HELOC is right for you and your unique circumstances.

What is a HELOC?

A HELOC is a line of credit that uses equity you’ve built up in your home as collateral. Since your home is used as collateral for the loan, HELOCs are considered secured loans. This means they typically come with lower interest rates than credit cards or other unsecured lines of credit.

Cash from a HELOC can be used for anything, but many homeowners tap into their home equity to:

• Finance a renovation, repair, or other home improvement project.
• Consolidate high-interest debts into a single monthly payment.
• Help pay for any other large purchase.

As a second mortgage, a HELOC won’t replace your current loan if you have one. In this case, you’ll continue to pay your monthly mortgage payment while also making payments on the HELOC.

How does a HELOC work?

HELOCs work similar to credit cards — the lender gives you access to a credit limit, and you can draw from that credit limit whenever you like. Unlike a credit card, the limit issued to you through a HELOC is dependent upon the equity you have in your home and your lender’s loan limits.

You’re not required to disclose what the funds will be used for, and there are no stipulations saying what the funds can or cannot be used for. Also, as a variable-rate loan, HELOCs let homeowners take advantage of lower starting interest rates than you’d typically find with credit cards, personal loans, or similar loans.

Pros of a HELOC

While a HELOC may seem a bit complicated at first, there are several potential benefits of using one to tap into your home equity:

• Lower interest rates: HELOCs are a great way to borrow money at a relatively low interest rate. They may come with rather low interest rates since they’re secured by your home. The lower rates make HELOCs a great tool for borrowing money at a low cost or for paying down higher interest debts.
• Only borrow what you need: Unlike home equity loans, HELOCs allow you to borrow the amount of money you need whenever you need it. When you’re approved for a HELOC, you don’t receive a lump sum of money upfront. Instead, you have a revolving line of credit that you can draw from whenever you need during a set draw period. This may be helpful if your project goes over budget or you need more cash — you can pull additional funds from the HELOC.
• Flexible repayment: Another great benefit of borrowing money through a HELOC is that you have a predefined draw period, usually 5-10 years in length. During the draw period, you pull as much or as little cash as you need up to your limit. Depending on your lender’s terms, you might only be required to make interest payments throughout the draw period and then repay the rest of the loan during the repayment period. This may vary between 10-20 years in length and will help you determine how much can expect to pay back on your principal amount monthly.
• Low initial payments: Many HELOC lenders may only require you to make interest payments throughout the draw period of the HELOC. Interest-only payments allow you to fully take advantage of the money you borrow.
• Use the money on what you want: With a HELOC, you can use the money you borrow for whatever you want. Loans such as auto loans require you to spend the loan proceeds on a specific thing. However, with a HELOC, you can use the cash for anything you want.

Cons of a HELOC

Although HELOCs are great for some, they’re not the perfect way to access capital for everybody. Here are some of the potential drawbacks of using a HELOC:

• Variable interest rates: Although HELOCs typically come with lower interest rates, the rates they carry are usually variable, similar to a credit card. This means your interest obligation can swing drastically from month to month, depending on changes to the prime rate. Significant rate changes can make it difficult to budget for your HELOC if interest rates rise rapidly.
• Higher payments during repayment period: HELOCs typically require borrowers to pay back their loan over a relatively short amount of time when compared to similar loans. This means that you may have a higher monthly payment with a HELOC than you would with another product such as a 30-year term home equity loan.
• The HELOC is secured against your home: A HELOC uses your home as collateral. If you stop paying your HELOC, the lender may foreclose on your home. This means that you could potentially lose your home. While this risk is not unique (mortgages and home equity loans are also secured against your home), it’s an important point to remember how this could potentially impact you if you run into financial hardship.
• Reduced home equity: Since you are using your home as collateral for a HELOC, your total home equity decreases as you draw from the HELOC and increases again as you make payments. While this is not something unique to HELOCs, it’s certainly something you should be aware of if you plan on selling your home soon.
• Risk of overspending: HELOCs act much like credit cards in that they are a source of capital that you can access relatively quickly. Some homeowners may wind up pulling out more money than they can comfortably afford to pay back. Often, borrowers use HELOCs to finance purchases that they otherwise would not be able to afford. This can put anyone with a HELOC in a difficult financial situation, especially if interest rates continue to rise over the loan term.
• Fees and costs: HELOCs may come with fees that borrowers must pay. While fee structures vary by lender, many lenders may charge annual fees, inactivity fees, early termination/prepayment fees, or transaction fees.

HELOC alternatives

If a HELOC doesn’t sound like the best way to borrow money, don’t worry. There are plenty of other options you can explore when you’re looking to borrow money.

Home equity loan

Home equity loans are very similar to HELOCs — they both serve as a second lien on your house, allowing you to access equity that you’ve built up. The main difference between HELOCs and home equity loans is that with a home equity loan, you get a lump sum of money upfront instead of access to a revolving line of credit. Home equity loans typically come with fixed interest rates that make it easy to budget for monthly payments and can be paid off over the course of 5-30 years, depending on how you structure the payback period with your lender.

A lump sum home equity loan may work better than a HELOC for large expenses that you have planned out ahead of time such as home renovations, paying for higher education, or consolidating multiple high-interest debts into a single monthly payment.

Cash out refinance

A cash out refinance is another way to access equity in your home. Home equity loans and lines of credit involve applying for a second mortgage secured by your house. However, cash out refinances are a type of mortgage refinance that lets you pull additional funds from your home equity, meaning the refinance loan will replace your current mortgage. When doing a cash out refinance, your new mortgage will have a higher balance than your previous mortgage since you’re pulling some of the equity out of your home. You could even potentially lower your existing mortgage interest rate depending on what rates are currently available to you.

Personal loan

Personal loans are another way to borrow money at low interest rates. While personal loan interest rates are typically not as low as for a home equity loan or line of credit, these loans are unsecured, so you won’t risk losing any assets such as your home if you can’t make regular payments. Although they may not come with the lowest interest rates, they may be a better option for those who are looking to borrow a smaller amount of money. Personal loans are rather quick and easy to be approved for — it typically takes longer for a HELOC or home equity loan to process.

Credit card

Lastly, credit cards are another way that you can borrow money to finance a purchase. While they typically come with the highest interest rates out of all the lending options on this list, they’re the easiest to use. Additionally, like personal loans, they’re rather easy to be approved for. Unlike personal loans however, you don’t receive the balance of a credit card as a lump sum to spend. It exists as an open line of credit for as long as you have it. This makes them a great tool to have in case an emergency comes up.