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Home Equity Line of Credit Basics

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Smart ways to use home equity

Tips and ideas on how to take advantage of the value of your home

As a homeowner, you may have a valuable resource in the form of available home equity. Home equity value is determined by subtracting the amount you owe on your mortgage from the appraised value of your home. Having home equity offers a way for you to access credit, in the form of a home equity line of credit, or HELOC.

Through a HELOC, a lender agrees to loan a borrower a certain amount of money for a set term, using the borrower’s home as collateral. While a HELOC can be useful to borrowers in a variety of ways, it’s important to consider the benefits and advantages of how to best use a line of credit. Here are 5 common home equity scenarios and why they might—or might not—make sense.

Investing in your current home

Improving your home through additions, repairs and renovations may help your home keep up with your changing needs over the years. Home improvements may also help increase your home’s value. But not all updates and upgrades can create future equity. For example, adding livable square footage and updating an outdated kitchen or bathroom may increase your home’s value. Green upgrades might boost your home’s value while lowering your energy bills—and may even provide further benefits in the form of rebates and tax credits (check with your tax advisor about interest deductibility). But overly personalized home improvements, like a custom wine cellar or photography studio may not add to your home’s value. So, it’s important to carefully consider what improvement you make to your home if you’re using a HELOC to fund those improvements.

Accessing lower-rate credit

HELOCs typically offer lower interest rates than other types of credit. While variable-rate credit cards can carry an average interest rate of 16%,Footnote1 the current average rate for variable-rate HELOCs is 4.81%Footnote2 (variable APR). But unlike with credit cards, the interest you pay on a HELOC is generally tax-deductible,Footnote3 and your tax advisor can give you all those details.

With a HELOC, you’re borrowing against the available equity in your home and the house is used as collateral for the line of credit. Like a credit card, as you repay your outstanding balance, the amount of available credit is replenished. This means you can borrow against it again if you need to, and you can borrow as little or as much as you need throughout your Glossary Term: draw period (which is usually 10 years), up to a credit limit established at closing. At the end of the draw period, the repayment period begins, which is typically 20 years.

While interest rates on HELOCs are generally variable—which means that the rate may change—some lenders offer a Fixed-Rate Loan Option for some or all of your balance. For example, if you want to make that kitchen upgrade, you can take out $20,000 for the project with a fixed rate. Your monthly payments will stay consistent and the interest rate won’t rise, making it easier to incorporate into your budget. Make sure you compare the interest rates of a variable-rate HELOC loan and a Fixed-Rate Loan Option and understand the costs associated with each, as the Fixed-Rate Loan Option is generally higher than that of the variable loan rate.

Consolidating debt

Considering that a home equity line of credit rate may be lower than a credit card rate, another scenario for using your available home equity is consolidating higher-interest rate debt with a HELOC. Using a HELOC for debt consolidation could help simplify your payments and reduce your interest costs.

You may save on interest by paying at least as much toward your new, lower-interest-rate loan each month as you had paid toward the higher-rate debt you wish to consolidate. But it’s not for everyone. The relative benefits of using a loan for debt consolidation depend on individual circumstances, and one benefit lies in not running up new debt after you consolidate your debts.

Funding higher education

If your children are heading to college or even if you’re contemplating going back to school yourself, a HELOC can be a way to help finance it, especially if you haven’t already saved enough through other channels like a 529 college savings plan. Since you can estimate educational expenses in advance, you should be able to figure out whether you’ll be able to budget the HELOC payments before you decide to take out the loan, which will help you determine whether this funding method makes the most sense for you.

Rethink expensive one-time purchases

Expensive discretionary purchases, such as vacations or an extravagant wedding, may not be the best reasons to draw on your home equity. Remember that your collateral for this loan is the place where you live, your home, so consider your options carefully.

Find out how to calculate your home equity, so you can make more informed choices on how to help reach your financial goals.