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The Beginner’s Guide To HELOCs

access_time Posted on: August 16th, 2019

house of cash as symbol for home equity potential

If you’re a homeowner in need of cash, a home equity line of credit might be for you. There are many ways to get the money you need these days. Depending on your circumstances, it can serve as a great alternative to a loan, credit card, or borrowing from a loved one.

What exactly is a HELOC?

A home equity line of credit (HELOC) is like a second mortgage on your house in exchange for cash. The amount of money you can get is based on the equity you have in your home. To determine your home’s equity, you use a simple calculation:

(85% of Your Home’s Value) – (Balance Owed on Mortgage) = Home Equity

If your home is worth $200,000, 85% of that is $170,000, so that will be used in the example below.

Example: ($170,000 home value) – ($100,000 mortgage balance) = $70,000 home equity

Also, keep in mind that you can draw from a HELOC and repay the total balance or a portion each month, similar to making credit card payments.

Good Reasons to Use a HELOC

A home equity line of credit can be an excellent option for you in many situations. Here are a few good reasons to get a HELOC.

Cover an Emergency

If you have an emergency, getting a HELOC can be a great way to cover your expenses. Whether you have to fund a medical expense or an unfortunate vehicle malfunction, using your equity can help get you through these tough situations.

Consolidate High-Interest Debt

If you’re paying high-interest rates on your debt, consolidating it with your lower interest home equity line of credit can save you thousands of dollars over time. Be sure to compare your current total payoff amount vs. what your payoff amount would be if you consolidated to determine how much you’ll save. The most common use for this is for credit card debt.

Make an Investment

Using your home equity line of credit to make a purchase that will generate income can a great way to invest your funds. You can make a down payment on an investment property or complete a substantial business investment with your HELOC funds. Just make sure you understand the risks involved with your investment when making the decision.

Reasons Not to Get a HELOC

While there are great reasons to get a HELOC, you don’t want to complete this process if it’s unnecessary. Here are a few examples of when you should bypass getting a HELOC and consider another financing option.

Funding a Vacation

If you need to get a home equity line of credit to fund leisure activities, it’s time to address the possibility that you could be living above your means. It is not designed as financing for vacations, business trips, weddings, big parties, etc.

Paying for College

While it may seem like a great idea to use your HELOC to pay for your–or your kid’s–college education, you might want to reconsider. Ultimately, you’re putting your house on the line in case you can’t repay. When there are other options available to pay for college, this generally isn’t the best method of choice.

Buying a Car

You shouldn’t purchase a vehicle with a HELOC because auto loan interest rates, in general, aren’t much lower than HELOC rates. This used to be a popular option since you could save money when auto loan rates and HELOC rates differed significantly; however, that’s not usually the case. We recommend that you stick with an auto loan for your next vehicle purchase.

Risks of a HELOC

Since you’re using your house as collateral against the borrowed cash, your house can go into foreclosure if you fail to make your payments. That is the most significant risk of getting a HELOC.

Your lender can always reduce or freeze your line of credit, and while this generally only happens when you fail to make payments, it is a possibility. Also, since your interest rate will likely be variable, your payment can fluctuate as the market does. Be sure to find out if there are caps on how much your rate can change.

Alternatives to a HELOC

There are other home equity funding options available other than a HELOC. Here are a few to consider.

Home Equity Loan

A home equity loan is similar to a HELOC because you use your home’s equity, and your home is collateral in case you fail to pay. However, you are paid a lump sum once your loan is approved, you usually have a fixed interest rate, and payments are made for a set amount over a predetermined period.

Cash-out refinance

A cash-out refinance requires that you fully refinance your mortgage. This is different than a HELOC or home equity loan, which are separate agreements. Since it is a full refinance, the interest rate on your mortgage could change, and you will be responsible for paying closing costs.

Is a HELOC for You?

Now it’s time to determine whether a home equity line of credit is the best option for you. To make that choice, you want to compare financing options that allow you to use your home equity and those that don’t.

Learn more about HELOCs

Here’s another resource to help you through your decision-making process. This article outlines in detail the difference between a home equity line of credit and a home equity loan to help you decide which is right for you.

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