Pros and Cons of a HELOC – Advantages and Disadvantages of Home Equity Line of Credit

A Home Equity Line of Credit (HELOC) offers advantages such as flexibility and sometimes lower interest rates but also has potential risks which should be considered such as variable rates and it will put a second lean on your home that if unpaid can cause you to lose the asset.  

HELOCs can be used for so many reasons and are great creative solutions to many people seeking solutions to trying to find money to grow their portfolio in real estate. If you have been around long enough you know that as you venture out into the investment market you sometimes will need upfront money to close your loan. HELOCs are great ways to borrow from your current primary property to get that needed down payment for the next property. Did you know that our lenders here at ADPI also have a NOO HELOC? Just a couple of days ago I confirmed while speaking with our in house lender that we now offer non owner occupied HELOCs. With that being said consider one of your previous purchases a couple of years ago that may have a bit of equity to be a potential to borrow off of! 

So as we dive into the details of a HELOC it is important to understand that simply borrowing the money and holding it may not be the best investment. Instead we encourage people to have a plan on what they are going to do with this cash! Let’s dig in and see if this product is something that could help you with your next purchase or a journey you are currently on to fix up your primary or even another journey

What is a Home Equity Line of Credit (HELOC)

A home equity line of credit or HELOC for short, works like a credit card where the borrower has a credit limit, but instead of using cash, they use the equity in their home as collateral. HELOCs are also known as a second mortgage. HELOCs have a variable interest rate and are typically used for major expenses such as home improvements, education, or medical bills. The borrower can withdraw money as needed and only pays interest on the amount borrowed. Repayment terms vary but typically involve a draw period during which the borrower can withdraw funds, followed by a repayment period during which the borrower must make monthly payments to pay back the loan.

What is Home Equity Loan

Home equity loans are a type of loan that allows homeowners to borrow money using the equity in their home as collateral. Home equity loans are also considered a second mortgage. The loan amount is typically based on the difference between the home’s market value and the amount owed on the mortgage. Home equity loans have fixed interest rates and are usually used for major expenses/debt paydown such as home renovations, personal loans, or education. The loan is repaid over a set period of time with fixed monthly payments. If the borrower is unable to make the payments, the lender may foreclose on the home which was used as collateral. A mortgage will have a lower interest rate than a home equity loan, as a mortgage holds the first priority on repayment in the event of not paying the payments and is a lower risk to the lender than a home equity loan. Home equity loans are different from a home equity line of credit, which allows for more flexibility in borrowing and repayment. 

HELOC Phases

There are two main phases of a Home Equity Line of Credit: the draw period and the repayment period.

• Draw Period: During the draw period, which typically lasts 5 to 20 years, the borrower can withdraw funds from the credit line up to the maximum amount allowed. The borrower only pays the interest rate on the amount borrowed and can choose to make payments towards the principal if desired. When the draw period ends the HELOC moves into the repayment period.
  
• Repayment Period: After the draw period ends, the borrower enters the repayment period, which can last 5 to 20 years. By paying off the debt sooner you can even save money on the interest rate. During the repayment period, the borrower must make monthly payments to pay off the remaining balance over the time period agreed to in the initial loan negotiations. The interest rate during the repayment period may be fixed or variable, depending on the terms of the loan.

Pros and Cons of HELOC

Pros

• Lower interest rates than credit cards
  
• Flexibility in borrowing and repayment
  
• HELOC interest rates can be tax deductible
  
• Allow using the equity in a home without selling or refinancing
  

Cons

• Losing the home if you don’t make the payments
  
• Variable interest rates that rise and fall with the market
  
• Good credit and sufficient equity in the home to qualify
  
• Fees to open/maintain the account
  
• Losing equity and potentially ending up owing more than it’s worth

Main HELOC pros

• Flexibility
  
  • HELOCs can be used for anything you want to use the funds for which is a major pro. A good strategy would be to use the funds to pay down debt with high-interest rates or invest the money into an investment LLC  that returns more than the interest payments you pay with the line of credit.
    
• Lower interest rates
  
  • HELOCs generally have lower interest rates due to the line of credit being secured by the home. It’s a good idea to take out a HELOC rather than a personal loan or max out credit cards to pay for something.
    
• Tax benefits
  
  • The interest rate paid on a HELOC can be tax deductible as long as you use the funds for improvements on the home. If you update a kitchen or repair foundation issues for example the amount you spent on it can be tax deductible. If you invest it in a life insurance policy or any kind of personal-related expenses it will not be.
    
• Access
  
  • Once the lender approves you, you can take funds out and use it just like a credit card. You can get an account card at your banking center that acts like a debit card connected to the HELOC account or you can easily do an online banking transfer to your personal or business accounts to get funds.

Additional Advantages of a HELOC

It’s important to keep in mind that a HELOC is a form of debt, and it should be used responsibly. That being said, here are some pros of the HELOC.

• Lower upfront costs: Compared to a traditional home equity loan, HELOCs often have lower upfront costs, such as application fees, appraisal fees, and closing costs. This can make HELOCs a more affordable option for homeowners who need to access their home equity.
• Competitive interest rates: Because HELOCs are secured by your home, they generally have lower interest rates than other types of loans, such as personal loans or credit cards. This can help you save money on interest over time.
• Improving credit score: Using helocs responsibly and making payments on time can help improve your credit score. This is because HELOCs are considered an installment loan, which can help diversify your credit mix and show lenders that you can manage different types of credit.
• Multiple draw periods: Some HELOCs offer multiple draw periods, which means that you can access your credit line for a set period of time, such as 10 years, and then repay the loan or refinance it. This can be helpful if you have ongoing expenses or need to access your home equity over an extended period of time.

You could qualify for a low APR

Depending on your credit score, income, debt-to-income ratio, and other factors the lender requires, you may qualify for a low Annual Percentage Rate (APR) on a HELOC. The APR is the interest rate plus any fees associated with the loan, and it is expressed as a percentage of the total amount borrowed. A lower APR can help you save money on interest charges over the life of the loan.

To qualify for a low APR, you need to have a good credit score, a low debt-to-income ratio, and a steady verified income. Lenders may also consider the amount of equity you have in your home and the purpose of the loan. If you are using the funds for home improvements, for example, you may qualify for a lower APR than if you are using the funds for personal expenses. Make sure when you are applying that the lender knows upfront if you are doing this on your primary or secondary home, this will change the agreement. 

HELOC interest might be tax-deductible

Under the Tax Cuts and Jobs Act of 2017, the interest paid on a HELOC is generally only tax-deductible if the funds are used to buy, build, or substantially improve the home that secures the loan. If you use the funds for other purposes, such as paying off credit card debt or financing a vacation, the interest is not tax-deductible.

It’s important to keep accurate records of your HELOC spending and interest payments so that you can calculate the deductible portion of your interest payments accurately. You should also consult with a tax professional to understand the specific rules that apply to your situation.

You can borrow only what you need

The great thing about this loan is that you can borrow only what you need to. By doing this you only have to pay interest on the amount you borrow. The more you borrow the higher your payment will be. 

HELOC Offers Flexible repayment options

Yes, that’s correct. A HELOC offers flexible repayment options. With a HELOC, you can access funds as needed, up to a predetermined credit limit established with the lender, and you only pay interest on the amount you borrow. You can also choose how much principal you want to repay at any time. 

High loan limits

The loan limit for a HELOC is determined by the amount of equity you have in your home, which is the difference between the current market value of your home and the outstanding balance on your mortgage.

Some lenders will allow you to borrow up to 85% of the equity in your home through a HELOC, although some lenders may allow you to borrow more or less depending on your individual circumstances.

Let us bring out the calculator and do some numbers:

For example, if your home is worth $500,000 and you owe $300,000 on your mortgage, your equity would be $200,000, and you may be able to qualify for a HELOC of up to $170,000 (85% of $200,000).

It’s important to note that just because you may qualify for a high loan limit on a HELOC doesn’t mean you should borrow the full amount. Borrowing too much can put you at risk of being unable to repay the loan, and can also put your home at risk of foreclosure if you’re unable to make your payments. Keep this in mind when making your decisions and also as stated before, make sure that you know what you are planning on doing with the money. With fees and charges for interest, money sitting in an account costing you money is not a great investment! 

HELOC Payments start out low

Your payments start out low during the draw period. You’re only required to make interest payments on the amount you’ve borrowed. This can result in lower monthly payments during the draw period compared to other types of loans where you’d be required to make principal and interest payments right from the start.

You only pay interest on what you borrow

You only pay interest on the amount you borrow, not on the entire credit line. This is one of the key benefits of this loan, as it can help keep your monthly payments lower compared to other types of loans where you’d be required to make principal and interest payments right from the start.

Let’s take a deeper look into the numbers. If you have a HELOC with a credit limit of $50,000, but you only borrow $10,000, you’ll only pay interest on the $10,000 that you’ve borrowed. This means that if you don’t need to use the full credit line right away, you can save money on interest by only borrowing what you need when you need it. This benefit alone is a giant point of interest for many people using this strategy. 

You can withdraw funds for many years

During the draw period which is typically 5-20 years, you will only pay interest on the amount that you withdraw. Once the draw period ends though you will not be able to access any more of the funds. 

You can use the funds however you like

You can use the funds any way you would like. There are no rules on how the money is to be spent. It is your cash after all that you have earned. Some good advice though is to only spend the funds on investing or getting rid of debt like auto loans, unpaid pet insurance claims, and personal loans. This is a loan and using it for non-essential expenses will raise the risk of defaulting and losing the home. Who would want to lose their home due to banking on getting that brand-new car or boat instead of using the funds responsibly. 

No fees for cash draws

While there are typically no fees for cash draws there are fees to open the account and specific lenders may even charge annual fees for the account.

Converting to a fixed-rate product

You are able to convert part or all of your loan balance to fixed rates during closing or the draw period. You are only able to get fixed rates during closing or the draw period otherwise you will have to refinance if you want to convert the variable rates to a fixed rate.

Potential to raise your credit score

Opening a HELOC will have a temporary negative impact on your credit score. By having the line of credit open and making regular payments over time the loan is a tracked event by major credit reporting companies and your score increases over time.

Home as collateral

With a HELOC you are borrowing against the collateral of your home creating a second mortgage. The good news is because your home is used as the collateral a lender sees you as a stronger borrower due to the asset held if anything goes wrong. The bad news is that if you don’t meet your financial obligations then you lose your home. 

Variable interest rates

Variable interest rates with a HELOC can be good or bad, depending on your financial situation and goals. Here are some of the ways that variable interest rates can be both good and bad:

Pros:

• Lower initial interest rates: Variable interest rates may start out lower than fixed interest rates, which can make the mortgage more affordable in the short term.
• Potential for lower rates in the future: If interest rates decrease, the interest rate on the mortgage may also decrease, which can result in lower monthly payments.

Cons:

• Higher interest rates in the future: If interest rates increase, the interest rate on the mortgage may also increase, which can result in higher monthly payments.
• Uncertainty about future payments: With variable interest rates, it can be difficult to predict how much you’ll owe each month, which can make personal budgeting more challenging.
• Risk of payment shock: A sudden increase in interest rates could result in significantly higher monthly payments, which can be difficult to manage if you’re on a fixed income or have a tight budget.

Overspending risk

A HELOC allows homeowners to borrow money against the equity in their home. While the loan can be a useful tool for accessing cash, it does come with the risk of overspending.

Since the loan is a revolving line of credit, it’s a fine line for homeowners to continue borrowing cash as they pay down the balance, leading to a cycle of debt. This can be very problematic if the cash is used for discretionary expenses, such as luxury purchases and paying for car insurance rather than necessary expenses like home repairs or medical bills.

Additionally, since the interest rate on the loan is typically lower than other forms of credit, such as credit cards or personal loans, it can be easy to fall into the trap of using the HELOC as a long-term source of financing, which can lead to a lot of debt over time.

To avoid the risk of walking the line of overspending with a HELOC, it’s important to have a clear plan for how the money will be used and to avoid using the line of credit for non-essential expenses. Homeowners should also make sure they have a plan for repaying the loan, including a budget and timeline for paying off the money owed.

HELOC Lowers Your Home Equity

While a HELOC is a solid option, it can also lower your home equity over time.

Each time you borrow money against it, your usable equity decreases. Additionally, if the value of your home decreases, your equity can also decrease, which can make it difficult to sell your home or refinance your mortgage.

To minimize the impact on your home equity, it’s important to use it responsibly and only borrow what you need. It’s also important to have a plan in place for repaying the loan and to consider the potential risks, such as changes in interest rates or a decrease in the value of your home. You should avoid using the loan as a long-term solution for financing and only use it when necessary.

ADPI Pro Tips

• Get all the information regarding a HELOC, they have a lot of different scenarios they can be used for, both good and bad.
• Borrow only what you need. Even though you have access to a lot of money all at once doesn’t mean you should spend it all at once.
• Shop around at different lenders for the best rates and to see if they offer a fixed rate program.