Even though housing prices have cooled, many homeowners saw their real estate values explode over the past few years. This has caused people to begin exploring options to tap into their newfound home equity.
One popular choice is a Home Equity Line of Credit (HELOC). A HELOC is a flexible borrowing tool that allows homeowners to draw from the equity they have built up in their homes. But is it a good idea? Let’s delve into the details and weigh the advantages and disadvantages of a HELOC.
Understanding a Home Equity Line of Credit (HELOC)
A Home Equity Line of Credit (HELOC) is a revolving line of credit secured by the equity in your home.
Equity refers to the difference between the current market value of your home and the outstanding balance on your mortgage. With a HELOC, homeowners can borrow up to a certain percentage of their home’s appraised value, minus the remaining mortgage balance.
For example, say your home value is $600,000 and you have a mortgage balance of $350,000. In this scenario, you have $250,000 of equity ($600k – $350k = $250k). If you want access to this equity, one option is to do a “cash-out” refinance. This would replace the current mortgage and any amount in excess from the old mortgage can then be taken as cash. The problem? A lot of homeowners have mortgages with rates under 4%, so a refinance would mean a higher mortgage rate.
This is why more people are turning to HELOCs to provide access to cash. A HELOC is a second mortgage, meaning it doesn’t replace the current mortgage. A lender will loan up to a certain amount of the value of your home, usually 80% to 90%. Using our previous example, the max loan a lender might provide is 80% of $600k, or $480,000. Because they already have a mortgage of $350k, that leaves $130,000 available for the HELOC.
Advantages of a HELOC
Flexibility: One of the most significant advantages of a HELOC is its flexibility. Unlike a fixed Home Equity Loan, a HELOC works like a credit card, allowing homeowners to borrow money as needed and repay it over time. This revolving credit line gives you the freedom to use funds for various purposes, such as home renovations, education expenses, or debt consolidation.
Lower interest rates: HELOCs typically offer lower interest rates compared to other types of loans, such as credit card or personal loans. Since the loan is secured by your home, lenders consider it less risky, resulting in more favorable interest rates. This can save you money in the long run, especially if you’re consolidating high-interest debt.
Tax benefits: The interest paid on a HELOC is tax-deductible if the funds are used for home improvements. This tax advantage can provide additional savings and make a HELOC an attractive option for homeowners looking to invest in their properties.
Emergency funds: Having a HELOC in place can serve as a safety net during unforeseen circumstances. In times of financial crisis or emergencies, having access to a line of credit can provide peace of mind and help cover unexpected expenses.
Disadvantages of a HELOC
Variable interest rates: While the initial interest rates on a HELOC may be lower, it’s important to note that most HELOCs come with variable interest rates. This means the interest rate can fluctuate over time, potentially increasing your monthly payments. We saw this happen in 2022 as the Federal Reserve hiked interest rates. Rates on HELOCs also moved up.
Risk of foreclosure: Since a HELOC is secured by your home, defaulting on payments could put your property at risk of foreclosure. It’s crucial to assess your financial stability and ability to repay the loan before considering a HELOC.
Temptation to overspend: The flexibility of a HELOC can be both a blessing and a curse. Some homeowners may be tempted to use the available credit for unnecessary expenses or non-essential purchases, leading to increased debt and financial strain. It’s crucial to exercise discipline and use the funds responsibly, considering long-term financial goals.
HELOCs can be a valuable financial tool for homeowners, offering flexibility, lower interest rates, and potential tax benefits. However, it’s essential to carefully consider the potential drawbacks and weigh them against other sources of funding.
Curious on ways to tap into your home equity? Connect with one of our home loan advisors to see what options are available to you!
