Home equity lines of credit, or HELOCs, come with a lot of benefits. These include flexibility, low rates (compared to personal loans and credit cards) and a long payoff window. The downside is that HELOCs also carry risk, because you could lose your home to foreclosure if you can’t keep up with the monthly payments.
If this tradeoff has you second-guessing whether a HELOC is the right choice for you, you can minimize the risk of borrowing from your equity by taking an intentional, strategic approach.
Equity lending described
Before exploring HELOC options, you should understand how home equity borrowing works.
Your equity equals your home's current value minus the amount you owe on it. You can borrow against this equity, preferably to pay for home repairs or renovations. You have three ways to tap equity: a HELOC, a home equity loan, or a cash-out refinance.
A HELOC is a second mortgage that is somewhat similar to a credit card, where you have a credit limit, and you can borrow as you need to up to that limit. Then you can pay some or all of the HELOC balance back, giving you room to borrow again.
A HELOC has a variable rate that goes up or down whenever the Federal Reserve raises or cuts short-term interest rates. The credit line has a draw period, often 10 years, when you can pay only interest each month. (Though you'll avoid a nasty payment shock later if you repay principal before you're required to.) Meanwhile, you keep paying your primary mortgage as usual.
With another type of second mortgage, a home equity loan, you borrow a specific sum at a fixed interest rate. You make equal monthly payments for a set number of years. Like a HELOC, this won’t affect your primary mortgage rate.
With a cash-out refinance, you refinance your mortgage for more than you owe, and deposit the difference into your bank account. The new home loan comes with a new mortgage rate. This tends to be a more popular option when rates fall, since you can refinance your mortgage and take out cash at the same time. If today’s rates are higher than your current mortgage rate, a cash-out refi is probably not your best choice.
Remember that rates could rise one day
HELOC rates move based on the prime rate, which moves based on Federal Reserve monetary policy changes. When the Fed decides to raise or lower the federal funds rate, the prime rate moves with it (usually at a markup of three percentage points). The Fed meets every six weeks to set borrowing rates.
In order to insulate yourself against variable rate swings, you could seek out a lender that allows you to lock the rate on some or all of your HELOC balance. That way, your payments stay predictable.
» MORE: Understanding HELOC rates
Don't borrow too much
There are no set rules about how a HELOC has to be used, so it’s important to focus on your financing goals. It can be tempting to keep reaching for your HELOC for small purchases, especially if your lender gives you a card that can live in your wallet next to your daily-use credit cards. This is how debt can grow and spiral beyond your means.
Your home is likely the most valuable asset that you own, in addition to being the roof over your head. You should only borrow against it to leverage yourself into a better financial position, not to buy your next cup of coffee.
Don't borrow for long
It’s wise to avoid using your home equity to finance an expense that you can’t reasonably pay off in a few years. The longer that it takes to pay back your balance, the more interest you’ll accrue.
A variable rate also becomes increasingly difficult to predict as your payoff timeline grows. Take it from a mortgage Nerd — it’s hard enough to try and predict what rates will do next month, let alone what they’ll do in 30 years.
Additionally, you’re banking on your finances remaining stable enough to keep up with monthly payments. If it’s going to take you decades to repay your balance, it’s not unfathomable to think that a financial emergency might come up at some point down the line — which could make those payments more strenuous.
HELOCs come with risk, but it can be worth it
Yes, HELOCs are technically riskier than unsecured financing options. However, a HELOC can also be a very useful financial tool when used appropriately.
Before you borrow against your home, make sure that you:
- Understand what you’re signing up for.
- Shop around for the best rate and terms.
- Borrow strategically to get yourself to a better financial position (for example, reinvesting in the home with repairs or renovations).
- Avoid taking on debt that will take many years to repay.
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