Home equity lines of credit: Pros and cons

Amy Fontinelle

By Amy Fontinelle
Amy Fontinelle is a personal finance writer focusing on budgeting, credit cards, mortgages, real estate, investing, and other topics.
Posted on Jul 12, 2022

A home equity line of credit, or HELOC, is a revolving line of credit secured by your home. In other words, a HELOC allows you to borrow against your home equity as needed by putting up your home as collateral.

Your home's equity is the difference between how much your home is worth and how much you owe on the loan you used to buy or refinance your home. If your home appraises for $500,000 and you owe $300,000, your equity is $200,000, or 40 percent of your home’s value.

If you’re looking for a source of emergency funds, a way to smooth out the ups and downs in your income, or relatively cheap financing for home improvements, a HELOC could allow you to borrow against a good chunk of that equity whenever you need it, then take up to 30 years to pay it back. (A HELOC is different from a home equity loan, where you receive the proceeds all at once.)

Understanding a HELOC’s pros and cons can help you decide whether this borrowing option might make sense for you.

Pros

Cons

Here’s a look at the pros and cons in more detail. 

Pro #1: You can borrow as much or as little as you want, up to your credit limit.

A HELOC is one of the most flexible forms of borrowing around. You can set one up in case you need it, then leave it untouched until you do. You won’t owe any interest until you actually use the money, except for a small annual fee (usually around $100) that some lenders charge.

A HELOC can give you access to quite a bit of money. Many homeowners, even ones who have barely put a dent in their principal balance, have more than enough equity to borrow against thanks to a hot housing market. The national median home price in the second quarter of 2020 was about $323,000; by the first quarter of 2022, it was about $429,000, according to the St. Louis Federal Reserve. In other words, the median home price jumped by 33 percent in less than two years.

Exactly how much can you borrow? Depending on the lender, your credit score, and what interest rate you’re willing to pay, you may be approved for a combined loan-to-value (CLTV) ratio as low as 70 percent or as high as 90 percent — maybe even higher. CLTV is the total of what you already owe on your home plus the amount of credit you want access to, divided by your home’s value. If your home is worth $500,000, your first mortgage balance is $250,000, and you want a $150,000 HELOC, you’ll need to get approved for a CLTV of 80 percent: ($250,000 + $150,000) / $500,000.

Home equity lenders tend to offer their best interest rates to borrowers who keep their CLTV ratio below 60 or 70 percent and establish a credit line of at least $100,000. You’ll typically need a credit score of at least 620 to qualify at all, and in the mid-700s to get a lender’s best rate. (Learn more: Improving your credit score: It pays off )

Pro #2: You can use the HELOC money however you want.

Even though your home secures the loan, you don’t have to use a HELOC just for home improvements. You could use your HELOC to invest in a rental property, cover your living expenses in months when your income is low, or pay off higher-interest-rate debts.

That said, you can’t claim a tax deduction for the interest you pay on your HELOC unless you use the money to substantially improve your main or secondary home. You also can’t deduct interest on more than $750,000 of mortgage debt from all sources ($375,000 for married couples filing separately). Most people don’t itemize, though, because they save more money from taking the standard deduction. (Related: How to avoid moving into a higher tax bracket)

Being able to use the money however you want also means a HELOC can tempt you to spend beyond your means on stuff that won’t make an appreciable difference in your quality of life.

“Because it’s so easy to write a check for $50,000 to take a really nice vacation, some people might be tempted to do that. They might spend the money frivolously,” said Joe Parsons, branch manager and senior loan officer with Pinnacle Home Loans in Dublin, California.

Pro #3: Establishing a HELOC is usually simple and inexpensive.

It’s not hard to find a lender offering a HELOC with zero closing costs. At worst, you might pay an early closure fee of up to $500 if you terminate your HELOC within 36 months — which you probably won’t do unless you sell your home.

A no-fee loan might seem surprising, given that the closing costs on a mortgage to buy a house are typically 2 percent to 5 percent of the amount borrowed, which typically ends up being thousands of dollars.

“The banks really want to do these loans because they’re very, very easy,” Parsons said. “Commercial banks are doing these up to an 80 percent CLTV, so they’ve got plenty of protective equity. The title and escrow fees for a second lien are very low, and they’re usually using a drive-by appraisal, which is cheap, or an AVM, automated valuation model, which is about $25. They’re getting prime plus something for their money, and it’s a pretty simple deal.” 

That said, you’ll still have to go through the usual mortgage application process and submit paperwork documenting your income. Loan approval can take several weeks, especially when demand for HELOCs is high and lenders are flooded with applications.

Pro #4: You can make low, interest-only payments for the first 10 years.

Because they’re secured by your home, HELOCs can be one of the cheapest ways to borrow money, at least at first. In fact, their interest rates are usually below what you would pay on a 30-year fixed-rate home equity loan, cash-out refinance, rate-and-term refinance, or purchase mortgage.

Some HELOCs even have a special introductory rate, where the lender might charge 1 percent APR for the first six months or 3 percent APR for the first 12 months when the going rate for a HELOC is more like 4.25 percent. Plus, most HELOCs allow you to make interest-only payments during the draw period, which usually lasts 10 years. Monthly interest-only payments on a $100,000 HELOC at 4.25 percent APR cost just $354 per month.

Home equity line of credit drawbacks

Given these four big benefits, establishing a HELOC might seem like an obvious choice. However, you’ll want to understand the drawbacks of borrowing against your home in this way before you make up your mind.

Con #1: Your home secures the HELOC loan, so your home is at risk.

The flip side of the low interest rate you get when you borrow against your home is that you can lose your home to foreclosure if you can’t keep up with your payments. Even if a lender will extend you a credit line up to 97.5 percent of your home’s value — and some will — you might not want to borrow that much.

Calculate what your monthly payment could be on different loan balances at different interest rates. Perform that same calculation for interest-only payments and for interest-plus-principal payments. See what your borrowing could cost you in the short run (monthly payment) and the long run (interest over as many as 30 years). Determine how you would make payments if your income decreased. (Related: 5 financial moves after a job loss

Know what the worst-case scenario is, then try to avoid it. Your loan servicer might work with you to make your payments more affordable in a pinch. But they’re not required to, so don’t make that your fallback option.

Con #2: The interest rate is variable and might double, triple, or quadruple over your loan term.

A HELOC has a variable interest rate. The rate is based on two things: the prime rate and the lender’s margin. The lender’s margin is fixed; changes in the prime rate are what cause a HELOC’s rate to change.

From December 2008 through November 2015, the prime rate never wavered from its all-time low of 3.25 percent. In May 2022, the prime rate stood at 4 percent. The target range for the federal funds rate, which heavily influences the prime rate, is expected to increase further as the Federal Reserve tries to curb inflation.

“The risk of a HELOC rate going up is absolutely a 100 percent legitimate concern,” Parsons said. “Someone who has a HELOC with a 4.25 percent rate today could be paying 5.75 percent by the end of the year, depending on what happens to the federal funds rate.” (Related: Interest rates and consumers)

To be financially prepared, you need to know how often your lender can adjust the APR, how much they can increase it from one adjustment period to the next, and how high it can get. Your lender must supply this information before you agree to the loan. Your loan terms might say the interest rate will never exceed 15 percent APR and never fall below 4 percent APR, for example.

If you borrow $100,000 with a HELOC, you need to understand that your payment might be as low as $333 if you’re making an interest-only payment at 4 percent during the loan’s draw period. Or, it might be as high as $1,264 if you’re making an interest-plus-principal payment at 15 percent during the loan’s repayment period.

Con #3: The bank can reduce or revoke your credit line at its discretion.

Relying on your HELOC for emergencies is dicey. If your credit score drops, home values drop, or mortgage investors get nervous about the economy, your loan servicer might slash your credit line or freeze it altogether. You’ll have access to fewer funds, or none at all, and you’ll still be responsible for your monthly payments. You might use a HELOC as a backup, extra-large emergency fund, but you should still keep your basic six months of living expenses in savings no matter what. (See: What to do when facing a financial emergency

A frozen or reduced credit line could also be a problem if you’re in the middle of a major home renovation and you suddenly can’t pay a contractor for completed work or fund the next phase of your project. Consider withdrawing the money before you need it. You can replenish your credit line anytime during the draw period with funds you don’t use.

Con #4: Making interest-only payments can come back to haunt you.

Lenders divide HELOCs into two time frames. The draw period, when you can borrow against as much or as little of your credit line as you want, typically lasts for 10 years. During that time, you can pay just the interest on your outstanding balance.

At the end of the draw period, your HELOC enters the repayment period. You can’t borrow any more money at that point, and you have to start paying back your loan principal in addition to interest. A typical repayment period is 20 years.

So, while a HELOC’s variable rate may be lower at the beginning, in the long run, your monthly payments and your total borrowing costs will be unpredictable. And if you opt for interest-only payments during the draw period, you might be shocked by how much you're responsible for each month during the repayment period if you haven’t done the recommended planning and budgeting. That’s why some homeowners prefer the stability of a home equity loan.

A helpful tool, if wielded carefully

HELOCs can be a helpful financial tool, but it’s important to know all their ins and outs before putting your home at risk. If you’re not sure whether a HELOC is right for you, a trusted financial professional can help you assess your options.

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The information provided is not written or intended as specific tax or legal advice. MassMutual and its subsidiarys, its employees, and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.