The most common options that the average person has for borrowing money are credit cards and personal loans, but homeowners have an additional possibility. A home equity line of credit (HELOC) is a particularly popular way to finance major expenses such as a home renovation.
Borrowers can use HELOCs much like a credit card, drawing on a line of credit established by the lender. Figure’s HELOC provides the full amount up front and borrowers can continue drawing on the HELOC as they make payments on the amount they’ve borrowed*.
If you're a homeowner, a HELOC offers advantages over a personal loan in the following areas:
• Debt consolidation
• Tax advantages
• Lower interest rate
• Improved credit score
- Debt consolidation
Experian's State of Credit Report says that the average non-mortgage debt in the United States was $25,104 per household in 2018, a statistic that indicates great potential for debt consolidation. At the same time, interest rates on equity-based loans like HELOCs have been near historic lows.
This combination makes HELOCs a superior option for debt consolidation, especially for homeowners with high equity. The generally low interest rate on HELOCs allows borrowers to save money when they pay off high-interest debts such as credit cards, car loans and personal loans.
It still might make sense to consolidate debt with a HELOC even if the refinancing will not save you money. The convenience of making only one payment per month greatly reduces the chances of missing a payment. Debt consolidation also gives you greater control over your debt, since you'll have one set of repayment terms and one date when you'll pay off your loan.
- Tax advantages
Depending on how you use the money, a HELOC can provide tax advantages that are unavailable with a personal loan. Prior to 2018, you could deduct the interest you paid on a HELOC regardless of how you spent the proceeds. Beginning with the 2018 tax year, however, you must use the money from a HELOC to buy, build or substantially improve the home that's securing the loan. Otherwise, you are not entitled to the interest deduction.
This change means that you will need to carefully track expenditures funded by the HELOC. That includes saving receipts from contractors and other professionals who improve or repair your home. Furthermore, the tax change greatly increases the incentive to improve your home if you take out a HELOC. A 2018 Bankrate survey shows that home improvements and repairs are by far the most popular reason to borrow against equity.
The flexibility of a HELOC gives it a number of advantages over a personal loan. In fact, many experts on personal finance recommend opening a HELOC as soon as you have sufficient equity to do so. The rationale for this strategy is that you pay interest only on what you spend from your HELOC credit line, whereas interest begins accruing on a personal loan as soon as you receive the lump-sum principal.
A HELOC’s untapped credit line makes it an ideal candidate to cover unexpected expenses. You don't have to touch it until you need it. This flexibility means that you can use your HELOC to pay for a major home improvement project all at once or a little at a time. With a HELOC, you can make minimum payments until you can pay off the entire balance, whereas a personal loan requires you to make the same fixed payment every month, regardless of how much of the proceeds you have spent.
- Lower interest rates
HELOCs generally have lower interest rates than personal loans. A HELOC is secured by the equity in your house, making it less risky to a lender than a personal loan, which is usually unsecured.
Another factor to consider is that HELOCs usually have a variable interest rate, while personal loans typically have a fixed rate. The variable interest rate on a HELOC means that it's best to pay it off early if you suspect that interest rates are going to rise. The recent downward trend in U.S. interest rates makes HELOCs preferable to fixed-rate personal loans.
Experian reports that the outstanding balances on HELOCs have slowly declined in recent years, while the available credit limits have continued to grow. Thus, there is potential for much more HELOC borrowing.
- Improved credit score
A HELOC can improve your credit score, whereas a personal loan tends to lower it. Credit utilization is one of the major factors that credit-scoring algorithms use to calculate your score. Taking out a HELOC increases the credit that's available to you, so your credit utilization rate will decrease if you don't use much of the credit line.
A lower utilization rate will result in a higher score. In contrast, a personal loan increases your debt, which can lower your credit score. Making timely payments on a HELOC is also a positive behavior that can increase your score. Keep in mind, though, that using a large portion of the credit line from a HELOC will increase your credit utilization rate, which can lower your credit score. Failing to make timely payments also will have an adverse impact on your score.
Weighing all of your options before borrowing money is vital, as it is with any financial decision. In the case of a HELOC or any other home equity loan, you need to be confident that your home won’t lose value due to a downward real estate market in your area, creating a condition where you have negative equity in your home. You always should stay on top of the equity remaining in your house.
*The Figure Home Equity Line is an open-end product where the full loan amount (minus the origination fee) will be 100% drawn at the time of origination. The initial amount funded at origination will be based on a fixed rate; however, this product contains an additional draw feature. As the borrower repays the balance on the line, the borrower may make additional draws during the draw period. If the borrower elects to make an additional draw, the interest rate for that draw will be set as of the date of the draw and will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. Accordingly, the fixed rate for any additional draw may be higher than the fixed rate for the initial draw. You must pledge your home as collateral, and you could lose your home if you fail to repay.