What Is a HELOC?
A HELOC—or Home Equity Line of Credit—allows you to borrow against a portion of the equity in your home. Unlike a traditional cash-out refinance, a HELOC is a separate loan or line of credit and allows you to retain your existing 1st mortgage, if you have one, and this is a 2nd mortgage in addition to what you already have.
The distinction between the two are particularly important for homeowners who already have an attractive rate on their primary mortgage.
If your current mortgage rate starts with a 2 or 3, you may not be particularly enthusiastic about replacing the entire thing with todays offerings, and I don't blame you.
Why Would Someone Use a HELOC?
Common reasons include:
Home improvements/upgrades
Debt consolidation
Major unexpected expenses
Education costs
Investment opportunities
Access to emergency liquidity
A HELOC is revolving credit, so borrowers can generally draw funds as needed during the applicable draw period rather than receiving the entire amount at once. As you pay the principal balance down, you have access to borrow again on the credit line.
When Can a HELOC Make Sense?
Suppose you have $60,000 in high-interest consumer debt. If accessing home equity allows you to substantially reduce the interest expense and monthly obligations, that may create meaningful financial relief, reduce interest cost and allow you to pay off the debt faster. But there's an important caveat to all of this that is important to consider....
Moving credit-card debt onto your house doesn't actually eliminate the debt. It changes where the debt lives. If the credit cards get paid off and then filled right back up...congratulations: we've made the problem bigger and now attached part of it to the house.
If the goal is to eliminate the debt, there must be a commitment to not continue the spending habits that led to the debt in the first place and stop utilizing the credit cards.
What About Home Improvements?
Using equity to improve the property can sometimes make sense, especially when the project adds meaningful usefulness or value to the home. But not every $50,000 renovation magically creates $50,000 of additional property value, thought - which is a common misconception among homeowners. Apparently buyers don't always value your custom imported tile and personalized touches as much as you do.
Understand the Rate
Many HELOCs have variable interest rates and/or interest-only periods. That means the cost of borrowing can change over time.
Before opening one, understand:
How the rate is calculated
Amortization schedule
Whether it can adjust
Minimum payments
Draw period
Repayment period
Fees
Maximum available credit
Flexibility is useful. But understanding the cost of flexibility is more important than the flexibility itself.
HELOC vs. Cash-Out Refinance
A HELOC isn't always the best way to access equity. Depending on your existing mortgage rate, the amount of cash needed, and your financial goals, a cash-out refinance or other structure may make more sense.
This is why I don't like starting with: "I need a HELOC."
Instead, start with: "Here's what I'm trying to accomplish."
Then determine the right tool to use for your desired outcome.
Key Takeaway
Home equity can be a powerful financial resource. But accessing it should have a purpose.
Use it strategically to improve your financial position, solve a problem, or accomplish an important goal.
Don't borrow against your house simply because the money is available.
Your home equity can be an incredible tool.
It just shouldn't become an ATM with a roof.
-Brian Kimball, Sr. Mortgage Advisor/Team Leader, The Lighthouse Group at Waterstone Mortgage