What is HELOC?
A Home Equity Line Of Credit, or HELOC, is a line of credit extended to a homeowner that uses the borrower’s home as collateral. It allows you to borrow up to a certain amount, rather than a set dollar amount. Based on household income and credit report, borrowers are pre-approved for a certain spending limit and may draw on this limit at their discretion. For this loan, you only pay interest on what you actually borrow. Additionally, there usually aren’t any closing costs. Normally, you are eligible to borrow up to $100,000 and the interest is tax deductible.
How does a HELOC loan work?
The first 5 or 10 years of a HELOC are known as the draw period. During this period, you can borrow from the HELOC and the minimum monthly payments are interest only. After the draw expires, the repayment begins. Repayment usually lasts for 20 years, where you pay principal and interest. It is structured in a manner that the entire loan is repaid in full by the end of the term.
Why use a HELOC?
- HELOC is an attractive way to pay off other loans because the interest is tax-deductible. Also, the rates of HELOC are just slightly higher than first mortgage rates. This makes them much lower than those on other types of loans.
- It is a good choice if you are not sure how much you will need to borrow or when. Generally, you can borrow against your line, repay it all or in part, and then borrow that money again later, as long as you are still in the HELOC draw period.
- Another common reason is that people use HELOC to pay for home improvements such as a new bathroom or kitchen. HELOC loans offer financing that won’t incur the double- digit interest rates of credit cards and the interest can be deductible if the money is used for a residence.
When not to use a HELOC
Here are some situations where you should avoid using a HELOC
- Buying a car: Since a car is a depreciating asset, with most HELOC loans, you are not required to pay down principal right away, opening up the possibility of making payments on your loan longer than the useful life of the car.
- Paying off credit card debt: In some cases, the debt transfer may not solve underlying behavioral issues. Using a HELOC to pay off your credit card debt can only work if you have the strict discipline to pay down the principal on the loan within a couple of years, and refrain from adding more debt to the cards.