How Does a HELOC Work? Part 3
What Do People Use a HELOC For?
Before applying for a home equity line of credit, make sure to have a plan for why you may need to use one.
Some use the equity in their home to make home improvements. Not only are the upgrades to your home satisfying your wants, the upgrades may add value to your home. When you go to sell your home, the added value could offset the cost of the HELOC during the home improvement period.
A home equity line of credit may be a great way to create an emergency fund. Many consumers open a HELOC and use it for emergencies. Remember, there is no monthly cost or interest when the balance on your HELOC is zero.
Often, parents choose to use a HELOC to pay for college expenses. If you have enough equity in your home, a HELOC may offer you a better interest rate versus private student loans. Also, with a HELOC, you only have to withdraw and pay back the amount you need. For example, if you need $20,000 for college, then you’ll pay that amount back versus a lump sum payment using a student loan.
Down Payment on a Second Home
Maybe you’re looking to purchase a rental property or a second vacation home. Saving the 20% down payment may take longer than you’d like, so an alternative is to utilize the equity in your home for the down payment right now.
When a HELOC May Not Be a Good Idea
While a home equity line of credit may seem like a great idea, there are instances where a HELOC is not your best option.
You Don’t Need to Borrow That Much Money
When you open a HELOC, there will be fees on the front end to complete the application. These fees may not be worth it if you’re only applying for a small line of credit. In this situation, a higher interest rate credit card may be a better alternative if you plan on borrowing a smaller amount of money.
To Pay for a Vacation
Frequently people pay for a vacation using a credit card, paying upwards of 20% APR or more in credit card interest. When you compare that to a HELOC rate, the better option is a HELOC at 6% APR.
It’s not wise to go into debt by borrowing money to fund leisure activities. When you expand your lifestyle using a HELOC, you are at risk. When you get behind with credit card payments, your credit is affected. When you get behind with a HELOC, your home is in jeopardy.
To Pay Off Credit Card Debt
Using a HELOC to pay off credit card debt makes perfect sense, right? After all, debt is debt, and you’re trading a higher interest rate debt for a lower rate debt.
While mathematically the numbers work in your favor, the risk is much higher. When you move your debt from a credit card to a HELOC, you’re moving from unsecured debt to secured debt.
Before you make the decision to use a HELOC to pay off higher interest debt, identify why you landed with excessive credit card debt. Make sure this process doesn’t repeat itself when you move the debt from credit cards into your HELOC.
You’re Moving Soon
If you know you’re moving soon, a HELOC may not be the best idea. After you sell your home, you will need to pay off the balance of the HELOC. This closes out the HELOC early, which may immediately result in an early cancellation fee to the lender.
If you have unstable income or anticipate your income decreasing, it may be wise to push pause on applying for a HELOC. Let’s assume your income fluctuates and you can no longer make the minimum monthly payments. When you stop making the minimum monthly payments on your HELOC, the home you live in is in potential jeopardy.
Check out the other posts in the How Does a HELOC Work? blog series!
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.