Consumers often mistake HELOCs and home equity loans for being the same thing. They are not. A home equity loan is a lump-sum payment, usually for a large project like remodeling or installing a pool. You start repaying the loan with fixed-monthly installments right away. A HELOC, on the other hand, is a line of credit that usually lasts 10 years. You can nibble away at it to pay for several, small home-improvement projects or you can use it in big chunks to pay for a vacation or wedding. The interest rate on HELOCs is variable and you could take as long as 30 years to repay them.
HELOCs and home equity loans share a key similarity: Both allow you to borrow against the equity you’ve built in your home and charge interest on the proceeds. But the way you borrow, how you repay and the way interest is charged, differs considerably between the two.
The Pros and Cons
Just like credit cards, HELOC credit lines are ripe for abuse. One of the reasons banks turned to restrictive underwriting standards after the 2007 financial crash is that many homeowners were using HELOCs as cash machines, assuming houses would increase rapidly in value and they could sell and pay off their HELOCs later.
The post-2007 experience taught everyone a lesson: Housing prices usually rise, but they can easily fall. A lot of money borrowed on a HELOC put many people in what is called negative equity, meaning they owed more than their houses were worth. That led to widespread foreclosures as homeowners stopped paying their debts.
Another lesson from the 2007 meltdown is that banks can lower HELOC borrowing limits overnight if they choose. When real estate price plunged precipitously during the market meltdown, lenders did just that, and people who were planning to use their HELOCs for anticipated needs like paying college tuition often were forced to look for alternatives.
Home equity lines of credit are also variable. The more you borrow, the larger you monthly payment, even if you are in an early period that only requires interest payments. Also, many HELOCs have adjustable rates, so your interest rate potentially could rise over time, adding to the monthly payment even if the balance doesn’t increase.
There are alternatives to HELOCs if you don’t like the uncertainty or know you don’t handle credit well. You could apply for a conventional home equity loan, or second mortgage, which is a one-time loan with a fixed repayment schedule. Some lenders want to know what you plan to use the money for, and the home equity loans often come with interest rates that are higher than HELOCs because the interest rate is fixed, instead of variable.
Cash-out refinancing is another option. It allows you to refinance your mortgage, borrowing more than you owed and taking the equity out in cash. In this case, you get cash to use as you wish and a fixed rate mortgage to repay. Obviously, you need to convince the lender that you can repay a larger loan.
Before you use your HELOC, an act that can put your home at risk, consider what you need the money for and how capable you are to repay it. Even if a lender approves your application, you are responsible for repaying the loan.