If you’re looking for a way to finance a major renovation on your home, one popular method is by taking out a HELOC (home equity line of credit). A HELOC is a type of second mortgage, but it takes advantage of the equity you already have built up in your home.
When most people buy a house, they pay a portion of the cost as a down payment and then take out a home mortgage for the rest. Homeowners don’t officially own the entire home and property in this case. Instead, you build up home equity—the total market value of the home minus whatever you owe the mortgage lender.
What is a HELOC?
A HELOC is a second mortgage that enables homeowners to use the equity they’ve built up through payments on their mortgage. If you have built up $75,000 in home equity, you might want to use that equity as collateral in a HELOC. Usually, lenders only approve a HELOC up to 85 percent of your equity and keep at least 15 percent as equity in the home.
People use a HELOC to finance a major expense, like a lengthy home renovation, educational costs, business ventures, or consolidation of medical or credit card debt.
A HELOC is like a credit card. It provides a line of credit for continuous borrowing up to a certain dollar limit and time period. You don’t get a lump sum. Instead, you can borrow as needed.
Phases of a HELOC
There are two primary phases of a HELOC—the draw period and the repayment period.
In the draw period, you can borrow from the line of credit as long as it’s open. You have to make payments, although they are minimal or might be interest-only.
In the repayment period, your home equity line of credit is closed and you make full payments on principal and interest.
Benefits of a HELOC
A HELOC can be a great option for homeowners who have specific needs.
- You only pay interest on the amount borrowed. If expenses are lower than estimated, you won’t pay additional interest on the remaining line of credit.
- You might secure a larger line of credit than you would with an unsecured personal loan.
- It’s useful for ongoing expenses like a long renovation project or tuition payments.
Drawbacks of getting a HELOC
A HELOC has a few drawbacks to consider as well:
It usually has a variable interest rate, so payments might fluctuate.
You’re borrowing against home value, which puts your home at risk if you aren't to repay the loan.
Alternative to a HELOC
A home equity loan is an alternative to a HELOC. Some of the differences include:
- Home equity loans are disbursed in a lump sum, so they’re more useful for one-time purchases like a roof repair than a HELOC.
- Home equity loans charge interest on the full loan amount, whereas a HELOC only accrues interest on the borrowed portion.
- Home equity loans typically carry fixed interest rates instead of variable rates.
Therefore, a HELOC can be a strong loan option to help finance major purchases or ongoing expenses, but you need to weigh other options as well.