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A lot of homeowners turn to secured loans like a Home Equity Line of Credit (HELOC) when it comes to having to pay for expensive home renovations and other real estate expenses. However, a little-known fact is that HELOCs can be used to pay other expenses as well.
In this short read, we’re going to help you understand your HELOC better, and the different ways you could use it, one among which is as a checking account.
What exactly is a HELOC?
A HELOC is a credit line extended to you by financial institutions based on the amount of equity in your home you have built over the years. Unlike home equity loans that offer you a fixed amount based on equity, HELOCs offer you a credit limit that you can draw over a period of time, similar to a credit card.
That period of time is called the draw period. Draw periods usually last between five to ten years, and the amount of credit offered is usually limited to a maximum of 85% of the equity you have in your home.
Just as in the case of credit cards, you only pay interest on the amount of money you spend during the draw period. Once the draw period is over, you are expected to pay both interest and principal on the amount borrowed.
While home equity loans offer a fixed interest rate, HELOCs offer a variable rate of interest. What this means is that the interest rate could increase or decrease based on the existing prime rates, or the lowest rate at which money can be commercially borrowed at that period of time. In fact, HELOC rates could fluctuate every month, depending on market conditions.
An important thing to remember is that HELOCs have fixed draw periods and repayment terms. This means that if the loan term is 30 years and the draw period is ten years, the repayment term is 20 years. However, if the loan term is 15 years and the draw period is 10 years, you only have 5 years to repay the loan.
However, that does not mean HELOCs are disadvantageous. As with anything, there are two sides to this coin as well.
Advantages of HELOCs
- HELOCs are the ideal home improvement loan, especially if you have a substantial amount of equity in your home.
- The amount of interest charged on a HELOC, even though it is a variable income loan, is considerably lower than the interest charged on credit card transactions.
- Being able to withdraw money from the line of credit offered, and paying interest only on that amount offers you better control of your finances.
- The interest paid on HELOCs is often tax deductible, which means you can save money on your annual taxes. Be sure to enquire with a tax professional to figure out how it works for your unique situation.
- The use of HELOCs is not limited to home improvements and real estate expenses. You can actually use your HELOC to pay for a variety of expenses, from medical bills and student loans to vacations and even weddings. In fact, you can even use the funds from your HELOC to pay off the IRS and consolidate your debts.
Disadvantages of HELOCs
- HELOCs are not ideal if you’ve just bought your home, or don’t yet have enough equity in it. There are, however, other home renovation financing options you could look at.
- HELOCs use your home as equity. If you default on your monthly payments, you could end up losing your home to foreclosure. As always, it is wise to exercise caution while borrowing money.
- To qualify for a HELOC, you need a lot more than just equity in your home. You will need a great credit score, a healthy debt-to-income ratio, proof of employment, and a lot more before approval.
- Keep in mind that HELOCs have variable interest rates. While it may make repaying the loan easier when the interest rates drop, be sure you can stick to your repayment schedule even when the rates rise.
Read more: HELOC amortization schedule
Smart ways to use a HELOC
Here are some of the ways you can use a HELOC smartly and benefit from it.
Reduce your debts
If you have outstanding debts, a HELOC is a great way to clear them off, since the rate of interest on a HELOC is generally lower than a credit card or a personal loan.
An example of using a HELOC wisely to reduce debt is to use it to pay off your existing mortgage. If the amount of equity you have in your home is more than what you owe on your current mortgage, you could consider using the HELOC to pay off your mortgage, and use the rest of the money to improve your cash flow situation or for renovations.
Of course, this makes sense only if you have more equity than what you owe. This way, instead of having to pay both a mortgage and the HELOC, you make only one payment, reducing your expenses.
However, if you choose to close existing loans with a HELOC, make sure you have a practical and effective long-term plan in place to repay it. The collateral used for the HELOC is your home, and you wouldn’t want to lose out on that.
While you could use your HELOC to pay for things like cars or vacations, things that might give you immediate satisfaction, these are not sound investments. Considering your home is the collateral for the loan, it would be wiser to invest in things that would appreciate in value over time.
Examples of such investments include necessary home improvements that will help increase your home’s resale value, such as an addition to your living space.
Use it as a checking account
If you earn more than you currently spend, using a HELOC as a checking account is one of the smartest things you can do.
Let us, for the sake of explanation, assume you earn $5,000 a month, and your monthly expenditure, including paying back your HELOC is $4,000 every month. If you use your HELOC as a checking account and put $5,000, or your paycheck, into it every month, you have an extra $1,000 left at the end of every month being redirected towards paying off the HELOC.
That way, your HELOC gets paid off earlier than it normally would, and you also end up paying less interest over the life of the loan.
Always take loans only if necessary
While loans such as HELOCs, second mortgages, cash-out refinancing, or even personal loans and credit cards may seem like the ideal way to deal with financial problems, it is worth remembering that the more debt we get into, the longer we are going to remain in debt.
Let’s consider an example. The average home mortgage period is around 30 years. If, after 15 years of paying the mortgage, you take a HELOC for 20 years, you’ve extended how long you’re going to remain in debt by five years and increased what you need to repay every month.
While it may seem difficult, it is wiser to spend within our means and have as little debt as possible. After all, we would not want to spend the rest of our adult lives only repaying loans, would we?
Read more: Should I lock in my HELOC rate?