It’s a number that seems hard to believe: Yes, since the beginning of 2020, the median home value in the United States has soared 70%.[1]
If you’re a homeowner, that means you could be sitting on a lot of equity—the difference between the market value of your home and the balance of your mortgage. If your mortgage is less than 80% of the value of your home, you could harness this equity to skillfully manage debt or build wealth.
There are two basic tools for borrowing against your equity: a Home Equity Loan and a Home Equity Line of Credit (HELOC). Both offer the advantage of borrowing money at an attractive interest rate.
However, according to Peter McCarthy, PNC Bank’s Head of Home Lending, there are important distinctions between the two products.
“With a standard Home Equity Loan, you borrow a specific amount of money against the equity in your home—and take on a standard set of payment terms.
“Meanwhile, like the name implies, a HELOC is a line of credit that allows you to tap into your equity on an as-needed basis. It provides greater flexibility in how you borrow—both when and how much. It behaves much like a credit card, but at a significantly lower interest rate.”
So, when does a HELOC come in handy?
HELOC Advantages
A HELOC is one way to leverage your equity to borrow money, with rates that are typically lower compared to credit cards or unsecured personal loans. As a result, many find it to be an attractive option for consolidating debt while reducing interest expenses.[2]
“As one example, a homeowner may use a HELOC to pay off credit card balances,” McCarthy advises. “The interest rate on a HELOC is usually lower than what you’d pay on a credit card. So, while you are effectively transferring your debt from one kind of loan to another, your overall interest payments will be far lower.”
Another advantage? Flexibility. A HELOC lets you borrow what you need only when you need it. Yet, if required, you can later borrow additional funds within your established credit limit. McCarthy provides a working example.
“Let’s say you have a HELOC in place for $50,000, yet you might only need to borrow $10,000 today. Then, six months from now, you might need to borrow another $10,000. A HELOC allows you to do that without having to return to the lender to apply for yet another loan.”
At the same time, depending on the lender, a HELOC may also have more flexible terms than a Home Equity Loan would have, including the option to choose between fixed rate and variable rate, as well as fixed or variable payments.
Finally, under certain circumstances, a HELOC may allow certain tax advantages when the funds are used to substantially improve the home that is the source of the funds.[3] However, as McCarthy cautions, “Tax regulations are subject to change. That makes it important to check with your tax professional to be sure that your particular HELOC, and how you use the funds, is eligible for a deduction.”
HELOC Disadvantages
While HELOCs are popular for both their affordability and flexibility, it’s also important to understand their downsides, too.
“The primary risk is using your home as collateral,” McCarthy adds. “That’s what makes a HELOC affordable. If there’s concern about your ability to repay, you should consider very carefully whether it’s prudent to risk your home should you become unable to pay the loan.”[2]
The other question? The large amounts of credit extended on a HELOC means the borrower should be prudent about how the funds are used.
“Because you’re leveraging your home, you want to be very thoughtful as to why you’re borrowing the money,” McCarthy continues. “We always advise borrowers to make future investments in themselves or their property, rather than finance something such as a vacation. Consolidating debt, improving your house, and gaining more education are healthier ways to borrow and spend.”
Before You Apply
Because the amount you can borrow is tied to the appraised market value of your home, it takes time for your lender to both approve the loan and decide what size your line of credit will be. This requires a longer approval process so, as McCarthy points out, thinking ahead is key.
As long as borrowers anticipate their needs in advance, a HELOC can be a very prudent option, as opposed to being forced to borrow with another type of loan at much higher rates.”
At the same time, it’s important to understand and address any credit issues before applying. One measure is understanding your Debt-To-Income ratio, the percentage of your pre-tax earnings will be committed to the repayment of your total debt.
“The requirement of lenders varies,” McCarthy offers, “But 40-45% of income obligated to repaying debt is usually the maximum ratio for lenders.”
It’s also a good idea to take stock of your current credit score before applying, clearing up anything that’s problematic. It not only could make the difference when it comes to approval, but it could also result in a better interest rate, too.
Finally, if you’re considering a HELOC, it’s always a good idea to speak with a mortgage professional well in advance. Armed with your financial information, a professional will ask about your needs and help determine if a HELOC is the right financial tool for your unique situation.
Home Equity Line of Credit (HELOC) - Home Equity Loans (pnc.com)
