How to Safely Use a Home Equity Line of Credit

Since 2021, the total balance on home equity lines of credit (HELOC) in the US has increased 45%, now sitting at $459 billion.

If you're fortunate enough to have a house and have adequate equity in that home, HELOCs can make a lot of sense. For starters, the average interest rate on HELOCs is currently 7.30%, which is a lot lower than you can get for a personal loan or a new credit card. On top of that, home values are rising, giving homeowners even more equity to play with.

But HELOCs aren't risk-free. Defaulting on a HELOC can end with you losing your home to a foreclosure, even if your primary mortgage is in good standing. So with that in mind, here are some tips for using HELOCs safely.

Borrow for a defined purpose or goal

HELOCs work really well for planned, substantial expenses, like renovations or replacing a roof. If you have a big project with a big price tag, using a HELOC can be more affordable. And if it's an improvement to your home, it could actually be considered an investment, since hopefully the value of your home will go up once the project is complete.

But even though HELOCs are technically "lines of credit" you really don't want to use them like a credit card. Dipping into your home's equity to help cover routine expenses is usually a bad idea and a sign that there are larger issues with your finances.

Plan for rate increases

Many HELOCs have variable interest rates, so the rate you start with may not be the rate you get stuck paying. While a variable rate means that the rate could go down, you should be prepared for the possibility that it will go up (and up...and up).

Before you open a HELOC, consider what the upper limit of your rate could end up being. Can you afford that? If not, you may want to look for other financing options. 

Don't spend to the credit limit just because you can

HELOCs tend to be for large amounts, and may even be quite a bit more than you need. But just because you were approved for $100,000 doesn't mean borrowing $100,000 is actually something you can afford.

Fight the urge to spend to your available limit. Be reasonable about what you can comfortably repay and don't spend over that line.

Be mindful of the draw and repayment periods

A HELOC typically has two distinct phases: the draw period and the repayment period. The exact lengths depend on the lender and your agreement, but here's how they commonly work.

The draw period is usually 10 years and it begins when your HELOC opens. During this period, you can borrow against the credit line, repay what you've borrowed, and borrow again (just like a credit card). Many HELOCs require relatively low minimum payments during this phase (more on that in a moment).  

Once the draw period ends, the repayment period begins. At this point, you generally can't make additional withdrawals. Your outstanding balance is then repaid over the period specified in your contract. Payments typically include both principal and interest, which is why the monthly payment can jump noticeably when the HELOC moves from draw to repayment.  

Be cautious with interest-only payments

Depending on the terms of your HELOC, you may be able to make interest-only payments during the draw period. These are the most affordable payments you can get, but they can really make life difficult once you hit the repayment period.

If possible, pay down principal from the beginning. Otherwise, you'll just be a kicking a massive and expensive can down the road.

Read the fee and rate terms carefully

Like any loan product, HELOCs can come with a variety of fees. Make sure you understand all of those fees upfront so you don't get caught paying more than you anticipated.

Some common HELOC fees include:

• Application or origination fee: Charged for processing or setting up the HELOC. Some lenders waive it.
• Appraisal or valuation fee: You'll need to appraise your home first to determine it's value, which helps establish how much equity you can borrow against. Depending on the lender, this might involve a traditional appraisal or a less expensive automated valuation.
• Closing costs: These can include title work, recording fees, document preparation, attorney fees, and other costs associated with establishing the lien on your home. A lender may pay some or all of them.
• Annual or maintenance fee: Some HELOCs charge a yearly fee simply for keeping the credit line open, even if you aren't currently borrowing from it.
• Transaction or withdrawal fees: A lender may charge for individual draws or impose minimum withdrawal amounts.
• Early-closure or termination fee: If the lender pays your closing costs, you may have to reimburse some of those costs if you close the HELOC within a specified period, such as the first few years.
• Late-payment and returned-payment fees: These can apply when a payment is late or a payment is returned for insufficient funds.

Be careful using a HELOC to consolidate credit card debt

The low rates on a HELOC can make it an appealing option to pay off credit card debt. In the right circumstances that can work, but it's awfully risky. Remember that credit cards are unsecured debt. When you don't pay them you might risk a lawsuit from your creditors or a wage garnishment, but you almost certainly won't lose your house over unpaid credit cards.

Consider other, less risky options first if you're struggling with credit card debt. If you can qualify for a HELOC you may also qualify for a debt consolidation loan. Alternatively, a debt management plan from MMI has no credit requirements and, on average, lowers interest rates below 8%.

Have an exit plan before borrowing

HELOCs are a long-term commitment, potentially sticking with you just as long as a traditional mortgage. And a lot can change in 30 years. So it helps to plan for all potential outcomes.

• What if your income decreases?
• What if rates go up?
• What if you want to sell the house?

You don't need a detailed plan for how to handle every possibility, but if you don't see a way through any of these scenario that might be a sign that a HELOC isn't worth the risk.

Looking for options to handle your credit card debt? MMI offers free financial counseling, 24/7. Enter your information and get a customized plan for your debt.