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Homeowners can access the equity they built up in their home over time. Lenders charge relatively low interest rates on a home equity line of credit because the home serves as collateral for the debt obligation.
Home equity is the difference between the value of the home and the amount you owe on your mortgage. For example, if your home is worth $200,000 and you owe $150,000 on your mortgage, you have $50,000 in home equity.
A home equity line of credit (HELOC) can be a great way to get the extra cash you need, but you should consider both the pros and cons before applying.
What Are the Pros of a Home Equity Line of Credit?
One of the highlights of a HELOC is flexibility. Unlike a personal loan or home equity loan, a home equity line of credit lets you use as much or as little of your total credit as you want. Rather than receiving a lump sum one time at closing, you get an open line of credit.
You can take the whole amount, pay down your balance, and continue using the remaining credit. You can also just use smaller amounts as needed. You have complete flexibility to use your credit as you need it.
Low Interest Rates
The low interest rates with a HELOC are also a top benefit. Since the home equity line of credit is secured by the underlying real estate, lenders do not consider it to be as risky as other forms of debt. However, the home equity line of credit is a second lien against the real estate.
If the borrower defaults on the line of credit, the lender would only get whatever money is left after foreclosing on the home and paying the mortgage balance. As a result, the interest rate on a home equity loan is slightly higher than mortgage interest rates, but it is still much lower than other unsecured forms of debt.
Another upside to this kind of debt is that the interest payments are tax deductible.
Until 2018, homeowners were allowed to deduct the interest they paid on their mortgage and home equity debt from their federal taxes. Although mortgage interest is still tax deductible, the rules regarding home equity debt have changed.
Interest on home equity debt is still tax deductible in certain circumstances. In order to qualify for a federal tax deduction, borrowers must use the proceeds from the home equity debt to make major home improvements that increase the value of the property.
What Are the Cons of a Home Equity Line of Credit?
A HELOC isn’t all sunshine. In fact, the application process is potentially difficult. The process of applying for a home equity line of credit is similar to the process of applying for a mortgage.
In addition to the formal application and credit check, lenders requiredocumentation that verifies all of the information on the application. That means you’ll need to submit recent billing statements for all debt obligations, pay stubs, and W-2 forms.
Then, you’ll have limited borrowing power. The dollar amount of the line of credit is dependent upon how much equity you have in your home. Lenders are only willing to extend home equity credit up until the borrower has a combined loan-to-value ratio of 80 percent to 85 percent.
In the previous example where the borrower owed $150,000 on the mortgage and had a home valued at $200,000, the loan-to-value ratio would be 75 percent. An 85 percent loan-to-value ratio would mean the borrower had loans totaling $170,000. So, the homeowner could get up to $20,000 as a home equity line of credit. If you only have close to 20 percent equity in your home, however, you may not be able to access as much cash as you need.
Putting Your Home at Risk
This is also a major thing to consider: the risk to your home. Since your home is the collateral on the home equity loan, you could lose your home if you cannot make the monthly payments on your home equity loan.
Using home equity credit is therefore much riskier to the borrower than an unsecured personal loan or other form of debt. The decision to open a HELOC should not be taken lightly. Weigh your options and be sure you stick to a budget – and only borrow what you can safely repay.
Author: Kimberly Goodwin, PhD