What is a HELOC?
A home equity line of credit, or HELOC for short, is one of the more flexible financing options in real estate.
A HELOC is basically a gigantic low-interest credit card that’s secured to your home. You can use it as much as you would like while it is open. During that time, even if you use it once and pay off the balance, you can use it again for other projects. Or you can choose not to use it at all and have the money ready to use just in case.
When Can You Take out a HELOC?
Most lenders will allow you to take a HELOC up to 80 percent of the property value minus any outstanding mortgage balances. You also have to meet lender debt-to-income ratio requirements, which usually only allow for all of your outstanding loan payments to be up to 45 percent of your monthly income.
As an example, let’s say you own a $300,000 home that currently has a $170,000 mortgage on it. Your maximum debt load on the property would be 80 percent of $300,000, or $240,000. This means that you would be eligible for a HELOC up to $240,000 minus $170,000, or $70,000.
That $70,000 can give you a lot of flexibility and carries a lot of advantages over other types of debt.
Advantages of a HELOC
As you can probably tell, HELOCs are quite different from your typical fixed-payment 30-year mortgage. This comes with its own unique advantages, as outlined below:
The number one benefit of a HELOC is its flexibility. You can take out any amount of money up to your limit, including none at all, just like a credit card.
This allows the borrower to stay very flexible in that he or she can use the HELOC at any time during the draw period. If the borrower has a HELOC with a $50,000 limit, but only needs $15,000, the borrower can just take out the $15,000. The borrower can take out the remaining $35,000 at any point after that.
While the HELOC is open, you can keep using it over and over again. Because HELOCs are revolving, paying off your balance does not close the loan. Instead, you can choose to take the money out again and use it as you wish!
This is especially helpful if you want to use the HELOC to invest in real estate. One strategy some investors use is to buy a property outright using a HELOC and then taking out a mortgage on the property after it is rehabbed, rented, and stabilized. The mortgage funds are used to pay off the HELOC balance, and then the investor is free to do it all over again.
The revolving nature of HELOCs helps to save on the costs of opening up an additional loan. The HELOC remains open for you to use it again without having new loan closing costs.
Lower Interest Rates Than Credit Cards
Most credit card interest rates hover between 18 and 26 percent, while HELOCs are typically within a point or two of normal 30-year mortgage rates.
Because rates are comparatively lower than a lot of other debt products, some people use HELOCs to replace their other debts. By consolidating their debt, they can potentially lower their total monthly debt payment significantly.
Similarly, some people use HELOCs to pay for their children’s college rather than face potentially higher rates from student loan lenders.
Using HELOCs to replace other debts entirely depends on your situation. If you are unsure if HELOCs would be a good option for you, consult a licensed financial professional!
Disadvantages of a HELOC
Sadly, HELOCs do have their disadvantages. Its important to understand all of them before even considering taking one out.
Variable Interest Rates
Even though interest rates might be low to start, with many lenders offering fantastic first-year introductory rates, most HELOCs have variable interest rates. This means that the interest rate can change at any time, depending on the terms of your HELOC. Often, the rate is pegged to the prime interest rate, which is the rate that banks charge to lend to one another.
This also means that an outstanding balance is at risk of seeing its minimum payments increase. Interest is not fixed, so neither are your payments. Thus, HELOCs generally carry more risk when used in long-term deals since more time allows for more potential changes to the interest rate.
Some HELOCs carry annual fees, much like credit cards. Granted, these fees are usually nominal compared to the size of the line of credit, but they are something to keep in mind.
Depending on your lender, there may be significant fees just to open up the HELOC in the first place. Every lender is different, so be sure to carefully check the terms of the loan.
Lien on the Property
Remember that great low interest rate compared to your average credit card? HELOCs have much lower interest rates because they give the lender a security interest on your home. This means that they will be able to foreclose on your home in the event that you do not meet your minimum HELOC payments.
However, this is just like any normal, fixed-rate mortgage. Be especially cautious when using HELOCs. Failing to meet payments can cost you your home, which is never something to play around with.
With a HELOC, you can use the funds for whatever you want.
But no matter what you spend it on, you will need to pay off the balance somehow. HELOCs can quickly turn into bad debt if they are not used properly. Always tread carefully when dealing with any amount of debt, especially when it involves your own home!
When a HELOC Makes Sense
In addition to debt consolidation and replacement, HELOCs can be great investment tools. As mentioned above, many real estate investors use HELOCs to finance their initial purchase or rehab on another property. Once that investment is stable, the investor can take out a mortgage on the property and pay off the HELOC balance so that it is ready to use again.
HELOCs can also be useful for financing larger, necessary expenses. However, like most debt, they should not be used for financing luxury items given the interest rate risk and threat of foreclosure on your home.
It also might make sense to take out a HELOC if it looks like a recession is looming. Setting up a HELOC while property values are at their peak is a great way to have access to a lot of capital without having to sell the property. It also locks in all of that appreciation that you may have earned over the previous few years.
When in doubt, consult a licensed financial professional to help decide if taking out a HELOC is right for you.
HELOCs are an extremely flexible debt instrument. They allow a borrower to use and reuse the equity in his or her home for whatever he or she wants.
With sensible risk management, HELOCs can be a great business tool. They also can help to lower expenses by consolidating other debts. The possibilities are rather endless, because the choice is yours with HELOCs!
But, as with any debt, with great power comes great responsibility.