A HELOC (home equity line of credit) is a type of revolving credit with a variable interest rate, comparable to credit cards. The line of credit is based on the equity in your home. It allows you to borrow and repay monies as needed over a certain period of time. Following that, you will repay the amount borrowed in installments.

Your home is the collateral for the line of credit, so falling behind on payments puts it at risk of foreclosure.

When you are authorized for a HELOC, you will be offered a credit limit depending on your home’s available equity. Borrowers can often borrow up to 80% of the value of their house (occasionally up to 85 or 90 percent, depending on lender policy and qualification), less any outstanding mortgage obligations.

During the initial draw time, you may spend the funds with specialized checks, a draw debit card, or an internet transfer. You will have to make monthly interest payments on the amount borrowed, but when you repay your HELOC, the funds will be restored. This draw time normally lasts ten years.

Following that, you will enter a repayment period during which you will no longer be able to access money and must repay the principal plus any outstanding interest. Most HELOC programs allow you to repay the remaining sum over ten to twenty years.

While you are usually solely responsible for interest payments during the draw period, you can pay both principal and interest if you like. This can help make your payments affordable when you enter the payback phase.

What Are the Creative Ways to Use a HELOC?

Over the previous few years, the housing market has been anything but normal. A combination of rising home prices, tight availability, and a high mortgage rate environment has resulted in buyers paying significantly more for their homes – as well as a quick growth in home equity levels. So, while many potential homebuyers are feeling the effects of today’s housing market, current homeowners are sitting well on piles of equity.

Currently, the average homeowner has approximately $200,000 in tappable equity in their property. You can use your home’s equity to pay off high-interest credit card debt, make a large purchase, cover unexpected bills, or do something else entirely. What’s appealing about borrowing against your home equity is that the interest rates are often significantly lower than those on a personal loan or credit card.

Home equity loans are not the only way to access your home’s equity. You can also borrow against your equity via a home equity line of credit (HELOC), which is a revolving line of credit secured by the equity in your property. What you may not realize is that, in addition to its numerous applications, this form of home equity lending product can be an effective tool for accumulating wealth and accomplishing financial objectives. Here is how.

A HELOC can be used to grow wealth in a variety of simple ways, including:

Home improvements

One of the most common and practical uses of a HELOC is for home improvements. By investing in renovations and upgrades that increase your home’s value, you are effectively building wealth in the long run. 

A higher home value means greater equity, which can be realized when you eventually sell your home. It’s essential to choose projects wisely, though, focusing on those that offer a strong return on investment.

Debt consolidation

Another strategy for building wealth with a HELOC is to use it for debt consolidation. By paying off high-interest debts like credit cards and personal loans, you can reduce your overall interest payments and save money in the long term. This strategy frees up additional funds that can be redirected toward investments or other wealth-building activities.

Investment opportunities

One of the most intriguing ways to use a HELOC for wealth-building is to invest in income-generating assets. You can use the funds from your HELOC to invest in real estate, stocks or other income-producing investments. 

This strategy involves risk, though, and it’s essential to conduct thorough research and seek professional advice when you need it. But if the returns on your investments exceed the interest rate on your HELOC, you can potentially build wealth through passive income and capital appreciation.

Emergency fund

While using a HELOC for investments or other wealth-building activities is enticing, it’s also crucial to have a financial safety net. Using a portion of your HELOC as an emergency fund can provide peace of mind. In case of unexpected expenses, you’ll have a readily available source of funds, which can help you avoid going into high-interest debt — thereby making it easier to build wealth slowly through your savings or investments.

Education and skill development

Investing in your education and skill development can also be a valuable wealth-building strategy. Using your HELOC to finance courses, certifications or degrees that can increase your earning potential can pay off in the long run. And, a more lucrative career or the ability to start a side business using the funds from your home’s equity can contribute significantly to your wealth.

Tax advantages

HELOC interest can be tax-deductible, depending on your jurisdiction and the specific purpose of the loan. Consult with a tax advisor to understand how this deduction can benefit your financial situation. While it likely won’t help you build wealth directly, this tax benefit can further enhance the wealth-building potential of a HELOC.

Read Also: How to Get a Mortgage With a Low Down Payment

When used carefully, a home equity line of credit (HELOC) can be an effective tool for generating wealth. However, HELOC techniques should be approached with prudence and consideration. Before using a HELOC, thoroughly analyze your financial objectives, risk tolerance, and potential return on investment. You may also want to consult with financial professionals, such as financial planners and tax advisors, to ensure you make sound selections. However, by using a HELOC properly, you can use the equity in your house to grow wealth and secure a brighter financial future.

What is the HELOC Strategy?

A home equity line of credit (HELOC) can help you finance major expenses or pay off debt. However, without a sound HELOC strategy, it’s simple to be in over your head. You may have heard about utilizing a HELOC to pay down your mortgage, but there are more methods to leverage your equity.

Below, we’ll look at the top HELOC tactics and which one is ideal for you.

A HELOC is a revolving line of credit that allows you to borrow money based on the equity in your house, which is the difference between the value of your home and the amount owed on your mortgage. A home equity line of credit works similarly to a credit card. You can borrow up to a set amount and pay interest only on what you use.

HELOCs often have lower interest rates than credit cards and personal loans since they are secured by your home. However, as the rate is frequently variable, your monthly payment may fluctuate over time.

A HELOC can be used for a variety of purposes, including home renovations, debt consolidation, medical costs, and even weddings. However, the true gain comes from leveraging your HELOC to achieve other financial goals.

HELOC strategy 1: Pay off your mortgage

The first and most common strategy is to use your HELOC to pay off your mortgage. 

If you’re approved for a line of credit sufficient enough to cover your remaining mortgage balance, you could use the money to pay off your mortgage. 

During the HELOC’s draw period (often 10 years), you have two options:

1. Make interest-only payments and redirect your extra cash flow toward other financial goals, such as saving for retirement, building an emergency fund or investing in your children’s education. 
2. Continue making your same mortgage payment and—ideally—pay your loan off faster. 

Advantages

A significant benefit of using a HELOC to pay off your mortgage is saving money on interest payments if you qualify for a lower rate. Plus, you have the flexibility to redirect your savings toward other priorities.

HELOCs often have lower fees than refinancing, so if your remaining balance is relatively low, it can be a solid way to get a lower rate. 

Risks

HELOC interest rates can change over time as the prime interest rate shifts if you have a variable rate (which is common with HELOCs). You might start out with a lower rate, but it isn’t guaranteed to stay there.

Another risk is that your mortgage payment may include property taxes and home insurance, which your HELOC won’t. Budgeting for these expenses on your own might be a challenge if you’re used to paying them as part of your mortgage payment. 

Some homeowners can deduct their mortgage interest payments from their tax return. If you use your HELOC to pay off your mortgage, you’ll lose this benefit. 

HELOC strategy 2: Increase your home’s value

Another common HELOC strategy involves using the money for home improvements that could increase the value of your property. By using the HELOC for renovations or upgrades, you could increase your home’s resale value or make it more attractive to potential buyers.

Compared to other strategies on this list, using a HELOC to increase your home’s value is a long-term investment that can pay off in the future. 

Advantages

Renovations can increase the value of your home, meaning more money when you sell it. They can also make your home more comfortable to live in and improve your quality of life. 

Plus, if you use your HELOC funds to “substantially improve your home,” the interest you pay on the loan may be tax-deductible.

Risks

Renovations can be expensive, so it’s critical to have a solid plan for how you’ll use your HELOC funds before you start. If your improvements don’t add value to your home, you may end up with a higher mortgage payment but no corresponding increase in value.

You’ll also want to ensure you’re not over-improving your home. This can make it harder to recoup your investment when you sell. Over-improving means making changes to your home that are uncommon and costly for your neighborhood. 

Also, using your HELOC to take on more debt means you’ll have to make monthly payments on the loan, so ensure you can afford the added cost.

HELOC strategy 3: Pay off debt

If you have high-interest debt from credit cards, payday loans, or personal loans, using a HELOC to pay it off can be a wise move. HELOC interest rates tend to be lower than these types of debt, so you can save on interest with this strategy. 

Using a HELOC to pay off debt isn’t as fun or exciting as using it for home renovations, but it can help you get back on your feet if you’re struggling to keep up with high-interest debt payments. 

Advantages

One of the main advantages of using a HELOC to pay off debt is the potential for significant interest savings. HELOCs tend to have lower interest rates than credit cards and personal loans, so you can reduce your overall cost of borrowing. 

Also, consolidating your debt with a HELOC can simplify your finances by reducing the number of monthly payments you make. One monthly payment versus multiple can help lower your stress and reduce your chances of missing a payment.

Risks

The biggest risk of using a HELOC to pay off debt is that you’re trading unsecured debt for a secured debt. If you can’t make your HELOC payments, you could lose your home.

Also, if you use your HELOC to pay off your credit card balances, you risk racking up more debt if you’re tempted to overspend on your cards again. If you use this strategy, ensure you also work on building good spending habits so you’re not trapped in a cycle of debt. 

HELOC strategy 4: Establish an emergency fund

Another strategy involves using your HELOC as a backup emergency fund. If you lose your job or have an unexpected expense, you could draw from your HELOC funds and pay it back over time. This strategy is similar to using a credit card for emergencies, but with a HELOC, you’ll likely have a lower interest rate.

It’s wise to have a separate emergency fund in a high-yield savings account, so you don’t risk losing your home if you can’t make payments. Still, using a HELOC as an emergency fund can work in certain situations. 

Advantages

One advantage of using a HELOC as an emergency fund is accessing the funds quickly if you need them. You’ll only pay interest on the amount you use.

Risks

One risk of using a HELOC as an emergency fund is that you may be tempted to use it for non-emergency expenses, which could lead to more debt. You’ll also need to ensure you have a plan to pay back the money as soon as possible.

HELOC strategy 5: Invest

Another HELOC strategy involves using your line of credit to invest in real estate. This could include using your HELOC to cover a down payment on a new property, make renovations, or purchase a property outright. 

HELOC interest rates tend to be lower than other types of financing, so this can help you lower the overall cost of borrowing and potentially increase your return on investment.

But be careful with this strategy. It’s riskier than other options on our list because it involves taking on more debt, and returns aren’t guaranteed. Talk to a financial professional, and consider your financial goals and risk tolerance before using it.

Advantages

One benefit of using a HELOC to invest in real estate is helping you build long-term wealth, especially if you purchase a property that generates positive cash flow.

Risks

Using a HELOC to invest in real estate can be risky if the investment doesn’t pan out. Also, interest rates on HELOCs can be variable, meaning your monthly payment could increase if rates rise. If you borrow too much with your HELOC, you could over leverage yourself and put your finances at risk.

The easiest strategy to select a HELOC lender is to compare offers from at least three sources. Compare interest rates, fees, and the maximum loan-to-value (LTV) ratio allowed. Your LTV is calculated by comparing your mortgage balance to the appraised value of your house, indicating how much equity you have.

Also analyze the terms, as well as the lengths of the draw and repayment periods. For example, if you intend to use your HELOC for home improvements within the next five years, your draw term should be at least that lengthy. Consider any additional features you’d like to have, such as the ability to lock in your rate during the term.

How Does HELOC Work?

A HELOC is a revolving line of credit. During the draw period, you can withdraw money as many times as you need using a check or a debit card, as long as it is less than your total loan amount. You must make minimum monthly payments, usually only for the interest that accrues throughout the draw period. As you repay your HELOC, the money is restored to your revolving balance (allowing you to continue drawing funds).

When the draw time ends, you enter the payback term, which typically lasts 10 to 20 years. You are no longer able to withdraw funds from your HELOC. During the payback period, your monthly payments will rise because you must begin repaying the principal (the amount you withdrew) as well as the accrued interest.

Because HELOCs are secured by collateral, such as your home, they often have lower interest rates than unsecured loans or credit cards. The disadvantage is that you risk losing your home if you fail to make payments.

Typically, you can borrow up to 85% of the value of your home, minus any remaining mortgage balance. To calculate your home’s equity, deduct your remaining mortgage balance from its current market value. So, if your house is worth $500,000 and you have $300,000 remaining to pay off your mortgage, you will have $200,000 in equity. If you borrowed 85% of your home’s equity, the loan would be $170,000.

How much equity you have in your home, how much debt you have, and your credit score all influence your chances of being approved for a HELOC, as well as the interest rate you pay.

For example, most lenders prefer a credit score of at least 700, but a lower score may be acceptable depending on your financial condition. However, a lower credit score is likely to result in a higher interest rate on your HELOC.

Requirements

• At least 15% to 20% equity in your home: Home equity is the amount of home you own. Subtract what you owe on your mortgage and other loans from the current appraised value of your house to get that number.
• Minimum credit score of 620: Lenders use your credit score to determine the likelihood that you’ll repay the loan on time. Having a strong credit score — at least 700 — will help you qualify for a lower interest rate and more amenable loan terms.
• A debt-to-income ratio of 43% or less: Divide your total monthly debts by your gross monthly income to get your DTI. Like your credit score, your DTI helps lenders determine your capacity to make consistent payments toward your loan. Some lenders may prefer a DTI of 36% or less. 
• Adequate, verifiable income: Proof of income is a standard requirement to qualify for a HELOC. Check your lender’s website to see what forms and paperwork you will need to submit along with your application.

Top 10 Uses for a HELOC

Many homeowners use their house’s equity to obtain a home equity line of credit. A HELOC is often a second mortgage with interest-only payments and lower rates than credit cards or unsecured debts. Don’t miss out on the top ten uses for HELOCs.

1. A HELOC can help you consolidate your debt

A HELOC can help you consolidate your debt by allowing you to use the equity in your home to pay off other debts. This can be a good option if you have a lot of equity in your home and you’re struggling to make payments on multiple debts each month. Since HELOC payments are interest only, they are typically much lower than other consumer debts.

It can also be a good option to get a lower interest rate than high-rate credit cards or unsecured loans. According to Forbes.com, the average credit card interest rate is 18%. Consolidating to a low rate mortgage may save you thousands in interest.

2. A HELOC can provide you with emergency funds

A HELOC can give you the financial flexibility to cover unexpected expenses when they arise. If a water heater needs replaced, or a vehicle breaks downs, the costs of repairs can be quite high. This type of loan can be a real lifesaver in times of need, providing you with the funds you need to keep your head above water.

3. A HELOC can help you finance home improvements

If you’re planning to make some home improvements and don’t have the cash on hand to pay for them, a HELOC can be a good option. With a HELOC, you can borrow against the equity in your home and use the money to fund your home improvement project.

Home improvements add value to your real estate which may help pay for itself when you sell your property. Just be sure to keep your borrowing within your budget and pay off your HELOC as soon as possible to avoid accruing interest charges.

4. A HELOC can help you pay for college tuition

A HELOC can also be used to pay for college tuition. This can be a good option if you do not want to take out a student loan, or if you want to avoid accruing interest on a student loan. However, you should be aware that if you default on a HELOC, your home could be foreclosed on.

5. A HELOC can help cover large medical expenses

In the event of large medical expenses, a HELOC may be a lifesaver. Using the equity from your home may be the solution to cover the large costs of surgery or medical expenses. For some, plastic surgery to improve yourself may be something you have always dreamed about. With access to a HELOC, you may be able to able to make it happen.

6. A HELOC can help you buy a second home or investment property

A HELOC can help you buy a second home by giving you access to the down payment funds needed to purchase the property. Typically, a second home requires at least a 10% down payment.

Using a HELOC for the down payment of a second home or investment property may be a good solution if you do not have cash on hand. Renting your property as an Airbnb may even offset your costs of ownership.

7. A HELOC can provide you with a flexible source of credit.

A HELOC can provide you with a flexible source of credit, which can be helpful if you need to make a large purchase or if you need to cover an unexpected expense. A HELOC also allows you to borrow only what you need, which can help you save money on interest since you only pay on what you owe. As you pay down the principal balance, your monthly interest drops.

8. HELOCs can help you avoid selling investments during a down market

The number one rule to investing in buy low and sell high. A HELOC can help you avoid selling investments during a down market because you can use the line of credit to pay for your living expenses.

This will allow you to keep your investments and avoid having to sell them at a loss. Since stock markets go in waves, you can plan on selling the stocks to pay down the HELOC when values are higher.

9. HELOCs can be used to pay for a wedding

A HELOC, or home equity line of credit, is a great way to finance a wedding. With a HELOC, you can borrow against the equity in your home with affordable payments for large expenses such as a wedding. Weddings can be very expensive and if don’t have cash saved then using the increased value of your home to cover the expense may be a great option.

10. HELOCs can be used to start a business

Ever heard the saying, it takes money to make money? When it comes to starting a business, this may be the case. A HELOC, or home equity line of credit, maybe the solution to starting a business.

This type of financing is often used by small business owners because it can be used as needed and can be repaid over time in affordable monthly installments. HELOCs can be used for a variety of purposes, including working capital, equipment purchases, and expansion.

HELOC Risks You Should Consider

You may have heard that a home equity line of credit (HELOC) is a simple, flexible, and cost-effective way to borrow money. All of these things are true if you handle your HELOC properly. Taking out a HELOC rather than a home equity loan means that you only pay interest on the portion of the line of credit that you actually use, rather than the entire amount that you are eligible to borrow.

However, if you are not careful, a HELOC can become quite pricey and land you in financial difficulties. Here are five ways a HELOC might harm you.

1. Rising Interest Rates Affect Monthly Payments and Total Borrowing

HELOCs generally have variable interest rates. The interest rate is based on a benchmark rate, such as the federal funds rate, plus a margin, which is established by the lender. When interest rates go up, your monthly payment will go up, too.

There is no way to predict when increases will happen or how much they will be. Your new monthly payment could be unaffordable. Getting behind on those payments can lower your credit score—not to mention increasing the interest that you owe. The fine print of your HELOC should state a maximum possible interest rate. However, if your current interest rate is 6% and the maximum is 20%, that information will not be very comforting.

Interest rates also affect your long-term total borrowing costs, not just your monthly payments. If your HELOC’s interest rate increases before you pay it off, the total cost of what you borrowed the money for goes up. A larger interest payment also means that you have less money for other things, such as paying bills or saving for retirement.

• Home Equity Loans

One way to combat the risk of higher interest rates is to take out a home equity loan, which has a fixed rate, instead of a HELOC. “In a rising-interest-rate environment, it may be better to have a home equity loan to lock in a fixed rate,” says Marguerita Cheng, CEO of Blue Ocean Global Wealth. Another possibility is to take advantage of the fixed-rate option that is offered with some HELOCs.

In exchange for the certainty of a fixed rate, you’ll generally pay a slightly higher interest rate than you would on a variable-rate HELOC. This dynamic is similar to the one between the interest rates for adjustable-rate mortgages and fixed-rate mortgages.

2. Fluctuating Monthly Payments Can Cause Financial Instability

Having a HELOC is similar to having an adjustable-rate mortgage in that your monthly payments can change significantly when interest rates change. It can be difficult to budget or make future financial plans when you cannot predict your monthly payments or total borrowing costs.

Of course, some borrowers are comfortable taking on this level of risk, especially in low-interest-rate environments. But if you need a lower level of risk to sleep soundly at night, then a home equity loan or a fixed-rate option on a HELOC may once again prove to be a better choice.

Jonathan Swanburg, investment advisor representative at Tri-Star Advisors, puts it this way: “Variable-rate loans are a terrific option if you are looking for low rates over the short term and could easily afford to quickly pay down the loan (or pay a significantly higher interest expense) should interest rates rise.

However, far too often, individuals take the savings from their floating rate loans and use them to increase their lifestyle by spending more on cars, clothes, or travel. Consequently, when rates rise, they can no longer afford the interest expense and find themselves in financial trouble.”

3. Interest-Only Payments Can Come Back to Haunt You

Some HELOCs have an option that allows you to make interest-only payments on the money you borrow during the first few years of the loan. Interest-only payments seem great in the short term because they allow you to borrow a lot of money at what appears to be a low cost.

In the long run, the picture is not so rosy. Borrowers face dramatically higher monthly payments once the interest-only period expires, and possibly a balloon payment at the end of the loan term. If you don’t budget for these increases—or if your financial situation stays the same or worsens—then you may not be able to afford the higher payments.

Plus, when you only pay the interest on a loan, the principal remains. The longer you wait to start paying off the principal, the longer you’ll make debt payments. And of course, you can’t pay off your loan until you pay off the principal.

4. Debt Consolidation Can Cost More in the Long Run

A low-interest HELOC can seem like a great way to consolidate high-interest debt, like credit card bills. It can even seem like a great way to refinance any debt with a higher interest rate than the HELOC rate, like a car loan.

When you extend your repayment terms from a few years to as many as 30 years, the overall cost of your debt may increase even if your interest rate is significantly lower. You’ll want to use an online debt consolidation calculator to determine whether you’ll come out ahead before considering this move.

Another problem is that, again, HELOC interest rates are variable. You might refinance at a lower rate now, only to have that rate increase later. When the rate increases, you may no longer be coming out ahead.

Debt consolidation with a HELOC can also cause problems for people who lack financial discipline. These people tend to run up their credit card balances again after using the HELOC money to pay them off. Then, they end up having more debt than they started with, and the problem that they were trying to solve grows into a larger problem.

5. Easy Money Facilitates Spending Beyond Your Means

A HELOC costs little or nothing to establish. Furthermore, interest payments are tax deductible under certain circumstances, just like mortgage interest. To top it off, accessing the money is as simple as writing a check or using a debit card.

HELOCs make tens of thousands of dollars readily available to you, and spending it feels just like making any other purchase. Under these conditions, it can be easy to rely on a HELOC to pay for purchases that your monthly income can’t cover.

Getting into the habit of living beyond your means is dangerous. It eats away at your savings and makes it extra difficult to get by if your financial situation changes for the worse.

Borrow money solely for long-term financial gains, such as house improvements. “When used just for house expenses, HELOCs can be quite beneficial. “Remodeling or home improvements are ideal,” says Elyse Foster, founder of Harbor Wealth Management. Aside from that, you should live below your means so that you can meet unexpected expenses without incurring debt.

If you decide to take out a HELOC, make sure you don’t get into difficulty.

HELOC Benefits

HELOCs can be an excellent alternative if you have a lot of equity in your house and know you’ll need cash on a regular basis over time, such as for college tuition. If you want to spend as you go and only pay for what you borrow, a HELOC is generally a better alternative than a lump-sum home equity loan, according to Murphy.

However, HELOCs may be dangerous. The variable interest rate could rise, and if you are unable to repay the loan for any reason, you may lose your home. Furthermore, you may get a false impression of bottomless cash throughout the draw time, which can lead to a harsh reality check when the payback term begins.

HELOCs offer homeowners a wide range of benefits. Here are more details about the advantages of HELOCs.

1. You can withdraw funds for many years

One of the biggest benefits of a HELOC is that it allows you extended access to cash. You can withdraw $10,000 here, another $30,000 there, pay it back, and withdraw even more. This makes a HELOC great for covering recurring expenses (like tuition, for example) or unexpected repairs, medical bills, and other charges that might crop up in the future.

“This method can be used over and over again as the funds are paid back,” says Esther Phillips, senior vice president and director of sales at Key Mortgage Services. “It’s a good option if funds are only needed for a short period of time or you’re unsure as to how much you need and when.” 

2. You only pay interest on what you borrow

Another perk of HELOCs is that you only pay interest on the funds you actually withdraw. If your credit line is for $50,000, but you only use $20,000, you’ll only be charged interest on that $20,000 — not the full line.

This helps to minimize your long-term interest costs, particularly compared to other loan options, which typically charge interest on your full loan amount from day one. 

3. You can use the funds however you like

There’s no restriction on how you use the funds from a HELOC. Many homeowners use them for repairs and renovations, while others use them for expenses completely unrelated to their home — like taking a vacation or consolidating credit card debt.

“The major advantage of a HELOC is that it has the same flexibility of a credit card,” says Deb Gontko Klein, a Chandler, Arizona, branch manager of Reliability in Lending at Primary Residential Mortgage Inc. “You’re only making payments on what was used and can pay it off and use it again as needed for home improvements, remodeling, landscaping, your kid’s college, or even paying off higher interest credit cards.”

4. High loan limits

Depending on how much equity you have in your home, HELOCs can potentially offer access to very large sums of money. Some HELOC lenders actually offer up to $500,000 in funding — much more than most other financial products can provide. 

As Adam Boyd, head of home equity lending at Citizens Bank, explains, “HELOCs generally offer larger loan amounts and lower interest rates than unsecured loans, lines of credit, and credit cards.” How much you ultimately qualify for will depend on how much equity you have and your credit score.

5. Payments start out low

Most HELOCs require only interest payments during the draw period, which can keep the monthly cost low. This can be helpful if you’re on a tight budget or need to preserve cash flow. Just keep in mind that your payments will increase to include interest and principal once you enter the repayment period.

6. Interest may be tax deductible

In some cases, you may be able to deduct your HELOC’s annual interest costs on your federal tax return. This is only the case if you use the borrowed funds to “buy, build, or substantially improve your home,” according to the IRS, so keep this in mind if you’re aiming for a tax deduction.

“Interest paid on a home equity loan or HELOC for any other purpose, such as buying an investment property or consolidating debt, isn’t tax deductible,” says Heather Harmon, head of Opendoor Finance, an online mortgage broker.

How to Manage HELOC Loans Effectively

A home equity line of credit (HELOC) is an excellent method to tap into the equity in your house to cover unforeseen bills or make home upgrades. However, because a HELOC is based on the equity in your home, it is critical that you manage it appropriately.

1. Make sure you can afford the payments. A HELOC typically has a variable interest rate, so your payments can go up or down depending on changes in the market. Make sure you can afford the payments, even if they go up.

2. Don’t use your HELOC for everyday expenses. A HELOC is a great tool for covering unexpected expenses or making home improvements, but it’s not meant for everyday expenses. If you use your HELOC for everyday expenses, you may find yourself in financial trouble if you can’t make the payments.

3. Have a plan to pay off your HELOC. A HELOC typically has a 10-year repayment period, but you may have the option to pay it off sooner. Have a plan to pay off your HELOC so you don’t end up paying interest on the loan for longer than necessary.

4. Consider a fixed-rate loan if you’re worried about interest rate changes. If you’re worried about changes in the interest rate on your HELOC, you may want to consider a fixed-rate loan. With a fixed-rate loan, your payments will stay the same, even if interest rates go up.

5. Don’t neglect your other debts. Just because you have a HELOC doesn’t mean you should neglect your other debts. Make sure you’re making all of your debt payments on time and in full to avoid late fees and damage to your credit score.

Managing a home equity line of credit effectively requires some planning and discipline. But if you use your HELOC responsibly, it can be a great tool for dealing with unexpected expenses or making home improvements.

To avoid undue financial difficulty or a negative influence on your credit score, utilize and repay your HELOC properly, just like you would with any other lending product. Here are a few crucial steps to take to make the most productive and successful use of your HELOC:

Make your payments regularly and on time.

HELOC payment amounts may change, but your due date will always be the same. Your HELOC is one more payment date to manage—create reminders to be sure you never miss one. Consider setting up automatic payments from your bank account.

Pay more than the minimum amount.

In the draw phase, you may only be required to pay off your interest. As with credit cards, pay more than the minimum required interest payment when you can. This will not only reduce your overall interest payments, like a credit card, it will free up those funds (your borrowing limit) to use later, if needed. 

Don’t use your HELOC for the wrong things.

Ideally, use your HELOC for things that will have long-term, meaningful effects on your family’s financial future. Avoid using it for non-essential expenses like travel and vacation, electronics, weddings, or everyday expenses. Additionally, while you may get a better interest rate than a car loan, because cars depreciate in value, it doesn’t make sense to put your home on the line for them. 

Good Reasons to Get a HELOC

A HELOC is a good source of financing for improvements that are completed in phases over time. It’s ideal for long-term home repairs since it allows you to borrow money as needed and just pay interest on what you’ve spent. A home equity loan, on the other hand, provides money in the form of a lump payment, making it ideal for a one-time investment like roof replacement. You pay interest on the entire debt from the start, regardless of whether you’ve spent it.

If you use a HELOC to renovate your house, the interest may be tax deductible – but consult a tax professional to confirm you qualify.

Interest rates on home equity lines of credit are often lower than on other kinds of consumer debt. The rates on HELOCs are lower because lenders can foreclose on your home if you fail to repay the debt. To put it another way: You pay a lower interest rate on a HELOC because you take a risk. With an unsecured loan, the lender takes more risk.

You can make a case for accessing a HELOC in the following situations. But you also might prefer to stick the lender with the risk rather than putting your home on the line.

To use as an emergency fund

You’re encouraged to amass an emergency fund to pay for big, unexpected expenses such as medical bills, major car repairs and unemployment. But after you have exhausted your non-retirement savings, a HELOC might work in a pinch.

Taking out a personal loan may be a better option because an unsecured loan doesn’t use your home as collateral. If you want to use a HELOC as a hedge against unemployment, you’ll need to open an account while you have a job, because you’ll need to document current income to qualify for a loan.

To pay for college

Many parents of college students can take out parent PLUS loans. But if you and your child aren’t eligible for federal student aid, you could borrow from a HELOC to meet college expenses. Or a HELOC might offer lower interest rates and fees than a parent PLUS loan.

Keep in mind that you risk foreclosure if you can’t pay the balance on a HELOC, whereas your home is not on the line with a parent PLUS loan.

To consolidate debt

It’s tempting to use a HELOC to pay off credit cards and other debt with higher interest rates. But you should do this only if you can stick to your plan to pay off the debt within three years — without charging up your credit cards again.

If you do not repay your credit card balances, your credit score will take a beating but the card company can’t take away your house. But if you pay off your credit card balances with a HELOC and then fail to make the payments on your home equity line, you risk losing your home to foreclosure.

Here are some common HELOC temptations and why they rarely make for a wise financial decision:

• To pay for a vacation: It’s not worth risking your home to pay for a dream vacation. The best way to pay for a vacation is with your savings. There are also travel credit cards and fly now, pay later travel loans.
• To finance a wedding: If you can’t afford to pay for a wedding or honeymoon without putting your home on the line, it might be better to scale back.
• To buy a car or truck: Auto loans are made for this purchase, reflecting a finance term that better suits the useful life of a vehicle. Putting your house up for a purchase guaranteed to rapidly lose value, and probably ending up paying for a vehicle long after it’s been retired, makes little sense.
• To start a business: This is a high-risk proposition at best, even without putting your home on the line.

HELOC Application Account Opening Disclosures

Unlike other forms of credit, Regulation Z, section 1026.40(b), requires lenders to disclose disclosures to consumers when they apply for a HELOC. Sections 1026.40(d) and (e) specify the obligations for providing these disclosures.

Content of Application Disclosures

Section 1026.40(d) requires the following disclosures:

1.       A statement that consumers should keep a copy of the disclosures;

2.       When the applicant must submit the application to obtain disclosed terms;

3.       That if the disclosed terms change, the consumer can receive a refund;

4.       That the consumer will be providing a security interest in their dwelling and that they may lose their dwelling if they default;

5.       A list of possible actions the credit union may take and the consumer may request information regarding when the credit union may undertake those actions;

6.       The payment terms of the plan;

7.       The APR;

8.       Fees that are imposed by the credit union;

9.       Fees imposed by any third parties to open a plan;

10.   That negative amortization may occur;

11.   That consumers should consult with a tax advisor;

12.   For variable-rate plans, various disclosures regarding the variable rate.

Beyond the above disclosures, section 1026.40(e) requires that the credit union provide the brochure titled “What You Should Know About Home Equity Lines of Credit.” Credit unions can find this brochure on the CFPB’s website. Credit unions may substitute another brochure instead of the CFPB’s if the substitute is comparable in substance and comprehensiveness.

Form of Application Disclosures

Before creating the above disclosures, credit unions should review section 1026.40(a), which discusses formatting requirements for the disclosures. Section 1026.40(a) lists the following formatting requirements:

·       The disclosures must be clear and conspicuous, grouped together, and segregated from unrelated information;

·       The disclosures may be provided either on the application or on a separate form; and

·       The disclosures required under section 1026.40(d)(1)-(4)(ii) must precede all other required disclosures.

For electronic applications, section 1026.40(a)(3) requires that the application disclosures be provided in electronic form. Comment 40(a)(1)-5 provides the following examples:

“i. The disclosures could automatically appear on the screen when the application appears;

ii. The disclosures could be located on the same Web page as the application (whether or not they appear on the initial screen), if the application contains a clear and conspicuous reference to the location of the disclosures and indicates that the disclosures contain rate, fee, and other cost information, as applicable;

iii. Creditors could provide a link to the electronic disclosures on or with the application as long as consumers cannot bypass the disclosures before submitting the application. The link would take the consumer to the disclosures, but the consumer need not be required to scroll completely through the disclosures; or

iv. The disclosures could be located on the same Web page as the application without necessarily appearing on the initial screen, immediately preceding the button that the consumer will click to submit the application.”

Credit unions may want to note that if the consumer accesses an application electronically but is physically present in the credit union’s office, the commentary states that the application disclosures may be provided in either paper or electronic form.

Account Opening Disclosures

Now that your applications are set up, it’s time to get ready for opening an account. To do this, credit unions should ensure that another set of disclosures are ready, the account-opening disclosures under section 1026.6. Section 1026.6(a) requires the following to be disclosed:

1.       Under what circumstances will a finance charge be imposed and how the charge will be determined, including;

a.        When the finance charge begins to accrue;

b.       The periodic rates that may be used to compute the finance charge;

c.       How the balance, on which the finance charge is computed, is determined;

d.       How the amount of any finance charges is determined.

2.       A list of other non-finance charges that may be imposed;

a.       Comment 6(a)(2) provides examples of other charges that may be helpful.

3.       Certain disclosures that were required by section 1026.40(d) to be included in the application disclosures;

a.       Credit unions should note that the requirement to disclose this information is separate from the requirements under section 1026.40.

4.       An explanation that the credit union is acquiring a security interest in the property;

5.       A statement outlining the consumer’s rights and the credit union’s responsibilities;

a.       For example, credit unions can review Model Form G-3 in Appendix G.

Credit unions should note that section 1026.5(b)(1)(i) requires that the above disclosures be provided “before the first transaction is made under the plan.”

Ways to Refinance a HELOC

Unless the HELOC is nearly paid off, refinancing it at any point throughout your payback tenure can be beneficial. However, it’s typically a good idea to try to refinance when the draw period is approaching to an end and you have a large outstanding debt. Your repayments are bound to increase because they will now include the principal.

If your credit score and income have significantly improved, you may be able to refinance at a lower interest rate or terms than when you first took out the HELOC. Also, keep a watch on interest rate trends. HELOC rates change, so if the trend is down, you’ll gain regardless. However, there may be some particularly enticing offers/teaser rates on new lines of credit.

If you choose to pay only the interest on your HELOC — instead of paying down a part or all of the principal — during the draw period, you may be in for a shock when you reach the end of it and the repayment period begins— especially if interest rates have risen since you first took out the loan. But even if rates haven’t substantially changed, your payments will likely be larger, since they will now include principal as well.

If you think you won’t be able to manage the payment increase, or if you have some additional projects you’d like to fund, you can refinance your HELOC. Even if the new interest rate is higher than that of your original loan, this might be the best option for you because it could give you the extra time you need to repay the funds.

There are a number of ways to refinance a HELOC depending on your unique situation.

Refinancing With a Fixed-Rate Loan

Most HELOCs come with variable interest rates, making it difficult to predict how much your payments will be month-to-month. A personal loan or home equity loan may be options borrowers can use to refinance into a fixed-rate loan. 

However, a fixed-rate home equity loan will likely have a higher rate than you’re currently paying. Personal loans also typically have higher interest rates than home equity products because personal loans are usually unsecured – meaning you don’t pledge collateral like your home to the lender in the event you fail to make your payments.

Personal loans and home equity loans are typically deposited as one lump sum into your bank account or paid directly to an existing loan. You can use that lump sum to pay off the balance of your HELOC and switch to a predictable fixed monthly payment.

Refinancing With a New HELOC

Another way to refinance a HELOC is to roll your existing balance into a new HELOC. While this isn’t always an option, some lenders may allow you to transfer the balance of your original HELOC into a new one with different terms. The benefit of this approach is you’ll enter a new draw period with the new HELOC and, in most cases, you’ll only have to make interest payments until the repayment period of the new loan begins.

Read Also: How to Get a Mortgage After a Bankruptcy

While this may seem like delaying the inevitable — and may actually cost more in the long run due to the risk of interest rates rising — refinancing into a new HELOC can be a useful option in some circumstances. For example, if your credit score has improved, you may want to refinance into a new HELOC to get a lower interest rate. 

However, refinancing into a new HELOC can be risky. If you’re refinancing because you’re having trouble making your monthly payments, starting over with a new draw period may cause temptation to continue borrowing. Once the new draw period ends, your financial situation could be even more tenuous.

Refinancing With a Cash-Out Refinance

A cash-out refinance is another popular way to refinance a HELOC. A cash-out refinance involves taking out a new mortgage on your home for more than you currently owe. You receive the difference in cash and can use some or all of the capital you receive to pay off the balance on your HELOC.

In essence, this means that you roll your HELOC into the cost of your new mortgage, where you’ll only be responsible for making one monthly payment. If you take this approach, it’s important to pay attention to interest rates as well as the closing costs and fees associated with taking out a new mortgage.

To calculate whether a cash-out refinance is in your best interest, you’ll need to consider the new interest rate and your new monthly mortgage payment, as a cash-out refinance will replace your current home mortgage with a new mortgage loan. In general, a cash-out refinance may be beneficial if your interest rate will go down. On the other hand, if your interest rate will increase significantly, you may want to consider other options.

While there are several ways to refinance a HELOC, the process for each is generally the same.

1. Evaluate Your Current HELOC

First, gather some information about your loan. The two easiest pieces of data to gather are your current outstanding balance and your repayment terms. You’ll also need to know about any fees you may owe, such as annual fees or transaction fees. 

From there, assess the interest rates you’re paying or may pay in the future. Most HELOCs have variable interest rates, so your rate may change as frequently as every month. To understand your interest rate, find out the underlying index your lender uses in its loans, the margin it adds on top of the index to determine your interest rate and your loan’s rate cap.

2. Compare Lenders and Offers

Once you’ve evaluated your current HELOC, shop different lenders to find the best refinancing option. Shopping around for the best offer can help you pay less in interest and find loan terms that work best for your unique situation. 

As you’re comparing offers, research the interest rates each lender offers, the fees charged for loan origination and the loan terms. Seek out customer reviews to learn more about what experience you might expect from working with a specific lender.

3. Apply for Refinancing

To apply for a HELOC refinance, gather the necessary documents a lender will review to see if you qualify. In general, lenders will want to know the following:

• If you have sufficient equity in your home (typically a minimum of 10% to 20% equity)
• Your credit score
• Your debt-to-income ratio

While specific documentation requirements vary between lenders, you’ll likely also need to provide a home appraisal, current mortgage statements and banking statements to a prospective lender. Depending on the lender, you may need to cover the cost of the professional home appraisal yourself.

There are a variety of ways to refinance a HELOC, including fixed-rate loans, new HELOCs, cash-out refinances and more. As you consider your refinancing options, carefully assess your reasons for refinancing so you can accurately research and compare different options.

Summary

A Home Equity Line of Credit (HELOC) is a type of loan that is secured by a person’s home. It is a sort of loan in which a bank or financial institution allows the borrower to withdraw loan cash as needed up to a certain limit. Because the collateral is a home, a HELOC is typically utilized for substantial expenses such as major home improvements, property purchases, medical bill payments, or schooling.

The structure of a HELOC is different from a mortgage, but both use a home as collateral. When a person decides to use a mortgage to purchase a house, they get the entire sum of the mortgage up front. On the other hand, a HELOC is more like revolving credit card debt. The person with the HELOC can borrow up to a certain maximum amount at whatever time they choose.

The second difference is the interest rate attached to the loans. For most mortgages, there is a fixed interest rate that is decided at the time the mortgage is signed. For a HELOC, there is usually a floating rate that is based on the prime lending rate. This makes a HELOC riskier as the borrower may have to deal with volatile interest rates. If the prime lending rate suddenly increases, then the borrower will have to shoulder the increased payments.

The third difference is the payment of the loans. For a mortgage, there are fixed interest and principal payments. They are often paid on a monthly basis and are decided when the mortgage is signed. A HELOC only requires interest payments. This, again, is similar to a credit card in which only a minimum payment is required and the principal payments can be pushed back. If a borrower uses $10,000 of the HELOC on a 2% interest rate, the borrower only needs to pay back $200 in interest and not the principal amount of $10,000. The principal is only required at the specified end of the draw period.

HELOCs are separated into traditional and hybrid categories. A traditional HELOC is as described above. The interest rate is floating and is subject to change, and there are no fixed payment requirements. The requirements for a traditional HELOC are more stringent. They typically enable the homeowner to borrow up to 65% of their home’s value. To qualify for a HELOC, the borrower usually needs to have at least 20% home equity.

A hybrid HELOC allows homeowners to borrow up to 80% of the home’s value. Hybrid HELOCs are more like mortgages, as a portion amortizes, which means it requires payments of both principal and interest.

Traditional HELOCs are considered riskier for lenders. This is due to the fact that borrowers only need to pay the interest payment, which is based on a floating rate. If the interest rate suddenly rises, then homeowners may find themselves in a situation in which they can not make the required payments.

Also, as with a mortgage loan, falling home prices may leave borrowers with “negative equity.” This means they owe more debt on their home than what their property is worth.

With a HELOC, you’re borrowing against the available equity in your home and the house is used as collateral for the line of credit. As you repay your outstanding balance, the amount of available credit is replenished – much like a credit card. This means you can borrow against it again if you need to, and you can borrow as little or as much as you need throughout your draw period (typically 10 years) up to the credit limit you establish at closing. At the end of the draw period, the repayment period (typically 20 years) begins.

A HELOC often has a lower interest rate than some other common types of loans, and the interest may be tax deductible. Please consult your tax advisor regarding interest deductibility as tax rules may have changed.