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How to Tell If a Home Equity Line of Credit Is Right for You

Leslie Tayne

Chances are, if you've searched for a way to fund a major expenses, you've probably come across the word "HELOC." But what is a HELOC and how can you know whether or not it's right for you?

A HELOC, or home equity line of credit, is a type of home loan that allows borrowers to open a line of credit using their home as collateral. Unlike traditional home loans, which are set at a fixed dollar amount, HELOCs enable people to draw any amount up to a certain limit. It's pretty similar to opening a credit card, except with a higher credit limit and higher stakes.

For example, let's say you qualify for a home equity line of credit for up to $100,000. You can then use that credit to help pay for home improvements, cover the cost of an unexpected medical bill or any other expense. However, in the event that you are unable to pay back the money you borrowed and default on the loan, the lender can foreclose on your home.

The Pros of HELOCs

Two of the biggest advantages of HELOCs are their flexibility and affordability. Because they're based on a line of credit and not a fixed amount, HELOCs are pretty versatile, so you can utilize as much or as little of it as you want. Additionally, because the loan is backed by the collateral of your home, interest rates tend to be lower than other alternatives. Plus, for a period of time, you'll only have to pay interest on the amount of money you borrow. So if you're confident that your financial situation will remain stable for the term of the loan, then a HELOC might be right for you.

The Cons of HELOCs

There are two major downsides when it comes to HELOCs. First, HELOC interest rates tend to be variable. So while the interest rate might initially be lower than other options, that is subject to change over time. Secondly, many HELOCs offer an option to make interest-only payments over the first couple years of the loan. While this might be nice in the short term, you may be shocked by significantly higher payments (and may even face a balloon payment) at the end of the term.

The Questions You Should Ask

In order to ensure you get the right HELOC for your particular needs, you're going to want to make sure you know the specifics details of your arrangement. Here are some things you might want to ask:

  • What's the HELOC's interest rate and how long does the introductory period last? Many HELOCs come with a low introductory rate but will eventually become variable.

  • What is the margin? Your margin is used when determining your post-introductory interest rate. Your interest rate will be prime plus the margin.

  • Is there a minimum draw requirement? Some HELOCs require you to take out a minimum amount of money before closing. Not utilizing your HELOC to at least the minimum could result in penalty fees.

  • Is there a required average balance? It isn't uncommon for HELOCs to require an average balance and therefore pay some interest.

  • Are there any fees associated with the account? Find out if there are any closing costs, annual fees or cancellation fees that come alongside your HELOC.

HELOC Alternatives

If you don't think a HELOC is right for you, there are plenty of alternatives available to help you with your particular financial situation. If you're looking to refinance your mortgage but want to avoid a varying interest rate, you might want to consider a home equity loan instead (yes, home equity loans are different than HELOCs). If you're seeking a means to consolidate your debt, consider consulting a professional or developing your own debt repayment strategy (here is a guide to getting out of debt). If you're worried about the possibility of major unexpected expenses, you may want to start building yourself an ample emergency fund. And is you need cash for home repairs or improvements, but don't want to put your home up as collateral, a personal loan could do the trick.

Most importantly, before taking out a HELOC or any other loan, you're going to want to make sure you've adopted positive credit habits. Making payments on time, keeping your credit utilization down, and using your credit for the right purposes can keep you from putting your finances in jeopardy. You can see how your debt and payment habits are affecting your credit by getting your credit scores regularly. There are many sources that offer your credit scores for free, including Credit.com.

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