When many think about getting a loan for something, they often turn to personal loans, home equity loans, or credit cards. But there’s another type of loan that’s worth exploring that may be a better option in some cases—a home equity line of credit.
What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is a type of loan that can be used for many different purposes. It functions differently than traditional loans in how money is distributed and repaid.
Unlike some loans, you have a great deal of freedom in how you use the money you borrow with a HELOC. Just a few things that HELOCs can be used for include:
- Funding college
- Funding vacations
- Home renovations
- Paying for unexpected medical bills
- Paying for hobbies and other interests
- Paying off credit cards and other high-interest debts
HELOCs use the equity in your home as collateral. How much you can borrow with a HELOC depends on the lender and the amount of equity you have in your home.
How Does a Home Equity Line of Credit Work?
HELOCs function more like credit cards than conventional loans. Instead of borrowing a certain amount and then repaying it with fixed monthly payments, with a HELOC you get a line of credit that you can draw from as needed.
Similar to a credit card, a HELOC credit limit can be replenished by paying back the money you borrow. HELOCs may be active for up to 10 years, which is called the draw period.
An important benefit of HELOCs is that you make interest-only payments on the money you borrow during the draw period. The money will eventually have to be repaid, of course, and a balloon payment will be required at the end of the draw period for the unpaid balance.
HELOCs also usually have variable interest rates. This could cause your interest payments to increase if rates go up sometime in the future.
When Should You Consider a Home Equity Line of Credit?
HELOCs are ideal for situations where you don’t know exactly how much money you will need for something or when you will need it.
A HELOC may also make sense for something expensive that you are considering buying with a credit card. Interest rates for HELOCs are usually significantly lower than rates for credit cards. Even with their variable interest rates, the savings from using a HELOC instead of a credit card can be significant.
Finally, a HELOC may also make sense if you need to buy something but you aren’t able to repay the borrowed money right away. A business that experiences seasonal fluctuations is an example. A HELOC could be used during the slow season and the money repaid when it gets busier.
Home Equity Line of Credit Alternatives
Although a HELOC is a great way to tap into the equity you have in your home, they aren’t ideal for all situations. The following are four HELOC alternatives to consider to help you select the best financing option for your needs.
A personal loan is an unsecured loan that can be used for many different purposes. You receive the full amount of the money you borrow upfront and then repay it over time with fixed monthly payments. Personal loans have lower interest rates than credit cards, and they usually don’t have any closing costs.
The application process for obtaining a personal loan is very simple, and loan decisions are usually made the same day. The terms for personal loans vary but are typically between one and five years.
A cash-out refinance is another way to tap into your home’s equity. With this financing option, you refinance your home for more than you currently owe. You then receive the difference in a lump-sum payment.
A cash-out refinance might be a good option if current interest rates are lower than the rate you are paying. It’s important to keep in mind that you will have to pay closing costs if you refinance your home.
Credit cards can make sense if you are making a purchase that isn’t overly expensive and that you know you can repay the money in a relatively short period. Credit cards usually have very high interest rates. The main benefit of using a credit card is that you don’t have to apply for a loan. A purchase can be made with the swipe of a card.
Home Equity Loan
A home equity loan is similar to a personal loan except that the equity in your home is used as collateral. Interest rates for these loans are usually lower than rates for personal loans.
What Should You Look for In a Home Equity Line of Credit?
When shopping for a HELOC, it’s important to consider the HELOC fees that some lenders charge. A few fees you should be on the lookout for include:
- Non-use fee
- Withdrawal fee
- Annual maintenance fee
- Penalty for early payment
Some lenders have more fees than others, so it pays to shop around to find the best deal. Also, some lenders offer HELOCs that don’t have any fees. The fewer fees you have to pay, the more money you can save.
Should You Choose a Home Equity Line of Credit?
A HELOC is a great way to tap into your home’s equity. It is highly flexible, interest rates compare favorably to other loans, and you have the option of making interest-only payments until you are better positioned financially to repay the borrowed money.
Before you select a loan, be sure you take the time to carefully evaluate the pros and cons of each financing option.