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What is a HELOC?

by Ryan Guina

A Home Equity Line of Credit (HELOC) is a flexible line of against the value of your home – you use your home’s equity as collateral. Usually, the borrower agrees to a certain maximum amount they can borrow over a specified time period. In some ways it is similar to a credit card because the borrower has a credit limit, and can take out money as needed as long as they don’t exceed the amount of the HELOC.

Why get a HELOC?

Home Equity Line of Credit HELOCA HELOC is a great way to have an available line of credit whenever you need a large amount of money. Many times the HELOC loan rates are better than credit cards because the debt is secured by your home equity (translation – if you don’t pay it back, your home could be on the line). Credit cards are unsecured loans and generally have much higher rates.

Many people use HELOCs to pay for home improvements, debt consolidation, or as a ready source of cash for an emergency fund. However, I don’t recommend using a HELOC as an emergency fund unless it is absolutely necessary. It’s best to have an actual cash emergency fund.

In many states, the interest payments for a HELOC are tax deductible (up to $100,000). This lowers the effective interest rate you pay on the loan. AMT rules or other laws may interfere with your ability to claim this deduction; do your research before borrowing with the assumption you can deduct interest payments.

Things to look out for with a HELOC

The interest rate on a home equity line of credit is usually variable and based on an index such as the prime rate plus a margin (the prime rate is the rate at which banks can borrow money). This means your interest rates can and likely will change. If your loan has a long amortization schedule, be prepared to have your payments change several times over the course of your loan.

The HELOC often comes with an annual fee, which is something you need to consider. Many times this fee is not disclosed, or is in the “small print.” Be sure to ask before signing any paperwork.

Your HELOC is secured by your home equity. That means if you do not pay your loan back, your home could end up in foreclosure. You should also be of your home’s value and how much equity you have. It is not wise to borrow more money against your house than your house is worth.

Get current rate quotes for HELOCs:

Do not borrow money with a HELOC just because a banker or lender says you can. Just because a lender sells you on the idea that you can tap your home’s value for a loan doesn’t mean you should. Only take out a HELOC because it is the best option for your situation.

Over the last few years real estate values increased dramatically and people used their home’s increased value as an excuse to upgrade their lifestyle by borrowing money they couldn’t afford to pay back. A vacation or a new car is not a good reason to borrow against your house.

Used correctly, a HELOC is a great financial tool. Used incorrectly, and you could be betting the house.


Published or updated February 23, 2012.
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{ 12 comments… read them below or add one }

1 Mrs. Micah

It’s sad to think that people might take out this loan just because a banker said they could/should. But then again, that’s why some people get into crazy mortgages…because they were qualified for it.

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2 Ryan

Mrs. Micah, I agree. Some people think they can afford something just because someone tells them they can. I have a hard time not saying anything when people comment about a car payment “only” being $400 per month! I’d rather invest that money. ;)

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3 Ron@TheWisdomJournal

A HELOC is a hole in your financial picture that allows you to buy depreciating assets with a mortgage against the future appreciation in your home.

The home I live in currently, though very nice (and new), was only two thirds of the price the bank said they would finance. I wish I had bought one that was even less!

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4 Ron@TheWisdomJournal

I agree, don’t get me wrong, it CAN be a good tool. Too many times though, it’s like using a backhoe to plant a tulip bulb. And very few people know how to operate a backhoe. :)

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5 Ryan

Ron, You’re right. Lenders will almost always give you the maximum number you can afford to borrow, rather than a prudent amount you can borrow. The problem with that scenario is that it doesn’t give you any room for other expenses. I think a HELOC can be a good tool if used properly, but usually there are better options.

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6 Ryan

LOL – agreed. Great analogy. ;)

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7 FourPillars

it’s like using a backhoe to plant a tulip bulb.

Hey, if the tulip bulb is big enough…?

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8 Kristin

I used a HELOC to pay off my home mortgage! WAMut first called me to re-finance. Their new rates were slightly lower than my loan, but I had plans to pay it off early and when I ran the numbers it just was not worth the paperwork. WAMut called back and suggested paying off my mortgage with a HELOC over 2.5 pts less than my loan – I took it and paid it off before the rate climbed back to my original mortgage rate.

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9 Ryan

I’m glad that worked out for you! I’m not sure it would work for everyone’s situation, but obviously that was a wonderful opportunity for you. :)

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10 RB @ RichBy30RetireBy40

Hey Guys – I wanted to share with you my HELOC philosophy. Essentially, we need it, and we need to spend all of it!

I think you’ll find the post intriguing.

http://www.richby30retireby40.com/2009/07/go-broke-to-win-big-heloc-edition.html

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11 lisa ramos

Would you advise getting an HELOC to pay off a debt? Currently going through a divorce, and trying to sell our home to pay off debt. However, it’s not a seller’s market and we hate to sell for so much below assessed value. We are contimplating getting back together, keeping house, and getting HELOC to pay off debt. We are 12 years into a 30 yr mortgage, and the debt is $14,000. Would we run into complications with HELOC if we decided to sell in future? Thanks…

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12 Ryan Guina

Lisa, I recommend working out your marriage issues before making any other major financial decisions, as things may be different depending on whether or not you and your husband go through with the divorce. Typically, though, I would rarely recommend getting a HELOC to pay off consumer debt because if you default on your HELOC, you could lose your home. It may also make selling the home more difficult, particularly if you are already underwater on your mortgage.

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