What are the pros and cons of a HELOC?

You’re well aware of the benefits you get from owning your own home. It’s a stable base you can rely on to stay comfortable when things change, whether that’s the passing of each season, growing older, or even just shifting aesthetic preferences.

You can magnify your home’s flexibility even further with a home equity line of credit (HELOC). It’s a popular tool among homeowners, and for good reason. That said, it’s not a cure-all, and there are some real downsides, as well. This post will cover the pros and cons of a HELOC to help you decide if it’s right for you or not.  

How a HELOC works

Learning how HELOCs work is key to understanding their flexibility. They don’t quite work like other financing options you might be more familiar with, such as your mortgage. Lenders typically break HELOCs up into two segments, starting with the initial draw phase and followed by a repayment phase. Let’s see how they work. 

Draw period

Most HELOCs come with a draw period lasting anywhere from five to 10 years. You’ll get a set credit limit that you can borrow against. When you borrow money, it’s called taking a “draw,” hence the name. Lenders might charge a fee for each draw, and they may require you to take draws at certain times to ensure you’re using your HELOC. 

Most HELOCs are structured to allow you to make interest-only payments during the draw period. This won’t pay down your balance, but you can always choose to do this on your own. If you do, you’ll save money on interest and refresh your credit limit so you can borrow again. 

Repayment period

The repayment period on a HELOC starts as soon as the draw period ends. You won’t be able to take any additional draws during this time. It essentially converts to a loan at this point, which you’ll pay off over the course of 10 to 20 years. 

HELOC requirements

You’ll need to meet a few criteria before you're eligible to take out a HELOC. Lenders vary in terms of how strict or accommodating they can be when it comes to the specifics, but in general, here’s what most lenders are looking for:

• Equity: A 20% or more equity stake is typically required, meaning that you “own” at least that much of your home’s value. In other words, your remaining mortgage balance shouldn’t exceed 80% of your home’s value. 
• Income: Stable employment is preferred over short-term self-employment. If you own your own business, lenders will generally scrutinize your income history a little more closely.  
• Credit score: 650 or higher, although some lenders are more willing to work with applicants who have lower credit scores. They may charge higher rates, however.
• Debt-to-income ratio (DTI): No more than 50% of your monthly income should be going toward the minimum monthly payments on your debt. This ensures you have the bandwidth to take on a new debt. 

The pros and cons of a HELOC

We’ve discussed some of the pros and cons of a HELOC, but there are additional factors to consider before making a decision. Here’s the full list of pros and cons of taking out a HELOC:

Pros

• Flexible terms: A HELOC allows you more freedom to choose your loan amount, timing, and even your payment amount, within limits. You can keep it as an emergency reserve and repay any funds immediately, or draw the full amount right away. In addition, you can use the funds for nearly any purpose. 
• Low interest rates: HELOCs typically offer lower interest rates compared to many other types of debt. That’s because the debt is secured by your home, rather than unsecured options like personal loans or credit cards. 
• High loan amounts: Depending on the amount of equity you have, you can potentially borrow a significant amount. If your home is paid off, for example, you can often borrow up to 80% of your home’s value. 
• Low initial payments: You can choose to only pay interest during the draw phase. While this does increase the long-term cost of your HELOC, it can be very attractive for homeowners facing temporary cash shortfalls in a way that’s not available with other financing options.
• Potential tax benefits: If you use the funds for home renovation or remodeling purposes, you may be able to deduct some of the interest you pay on your taxes in the same way you do for your mortgage. A HELOC is, after all, considered to be a type of second mortgage.

Cons

• Foreclosure risk: You could lose your home if you run into problems paying back your HELOC. It’s a risk that’s present with any type of home financing, but because HELOC payments can fluctuate, it’s especially important to be aware of the potential for foreclosure if you decide on this option.
• Many types of fees: HELOCs typically come with closing costs ranging from 2% to 5% of your approved credit limit. Some lenders also charge a fee each time you take a draw, or they may charge an ongoing maintenance fee. 
• Variable interest rates: HELOCs have variable interest rates, similar to credit cards. This can make it more or less expensive to use your available credit, depending on the overall state of the economy. It can also cause your monthly payment to change, too.
• Complicated structure: HELOCs can often be difficult to understand. In addition, your monthly payment amount can change drastically over time depending on how much money you’ve borrowed, what phase of the HELOC you’re currently in, additional fees the lender may charge, as well as interest rate shifts. 
• Difficulty selling the home: If you have an outstanding HELOC balance when you try to sell your home, it’ll be paid off with the proceeds from the sale, same as your mortgage. That leaves even less left for you to purchase a new home, and can complicate the home sale if the agreed-upon price isn’t high enough to cover your combined HELOC and outstanding mortgage balance.  
• Long underwriting process: It typically takes a few weeks to go through the entire underwriting process. You are taking out a second mortgage, after all, and that requires a lot of additional steps, such as obtaining an appraisal to determine your home’s value, verifying the title, and confirming your existing mortgage, among others. 

When a HELOC makes sense

The defining feature of HELOCs is their versatility. Homeowners can use them for just about anything. That said, because it’s structured as a low-cost line of credit, it’s particularly well-suited for certain applications:

• You want a backup source of funds for emergencies.
• You’re working on a DIY or long-term home renovation project. 
• You have other ongoing borrowing needs.

Potential HELOC uses aside, it’s also important to analyze whether it’s a good fit for your financial profile and personal comfort level. Certain people might be a better match for a HELOC than another type of financing:

• You have a stable income and decent credit.
• You’re not planning on selling your home anytime soon.
• You have enough free cash flow each month to pay your HELOC even when rates change, and you enter the repayment period. 

Alternatives to HELOCs

If a HELOC isn’t in the cards for you, there are still plenty of other financing options. 

Credit cards

Credit cards also allow you to borrow against a preset credit limit, but it’s not directly attached to your home, so there’s less danger of losing it if you run into problems. However, loan amounts are typically much less, and rates are often much higher. 

Personal loans

Personal loans also aren’t secured by your home, which means that rates are typically higher. However, you may be able to borrow more with a personal loan than with a credit card, and they also come with fixed rates that can make repayment easier, too.

Home equity loans

Home equity loans offer a compromise between personal loans and HELOCs. They come with lower rates since they use your home as collateral, but they’re also disbursed as a lump sum with a fixed interest rate. That makes for a simplified payment structure.

Reverse mortgage

A reverse mortgage can provide funds in the form of a monthly payment, a lump sum, or a line of credit. Unlike most other loans, it doesn’t require monthly payments; you repay it by handing over the title to your home when you no longer need it. To qualify for a reverse mortgage, you must be over 62 years of age. 

Cash-out refinance

If you need a lump sum of funds and can get better terms on a new mortgage, a cash-out refinance can allow you to accomplish both goals at once. Instead of owing two debts, you’ll repay a single larger loan. 

Home equity investment (HEI)

An HEI offers a lump sum of funds without the need for monthly payments. Home equity investments aren’t technically a loan, but still worth consideration. You’ll repay the amount you borrowed plus a share of your home’s appreciation in value after a 30-year period. 

Final thoughts

A HELOC gives you additional flexibility when you need to borrow money in the future. No one knows what the future holds, but with a HELOC, at least you’ll have a quick and cost-effective way to pay for things you might need, even if you don’t always know exactly what they are yet. 

Even though a HELOC can be a handy thing to have, it’s just a tool — and like all tools, it may not be right for everyone. That’s why it’s important to keep an open mind and consider other options, which might work even better to your advantage.  

Tap into your home equity with no monthly payments, no income requirements, and no need for perfect credit. Explore how Point’s HEI works today. 

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