If you’ve got a big expense coming up but don’t quite have enough savings to cover it, you might think a home equity line of credit (or HELOC) could help you pull together the cash for the job.
But what exactly is a home equity line of credit? How does it work? And is it really a good financing option for things like a home remodel, retirement living or college tuition? The answer’s no! A HELOC may sound like a good idea, but it’s actually one of the biggest financial traps you can fall into.
Let’s take a look at why HELOCs are bad—and what you can do instead.
What Is a Home Equity Line of Credit?
A home equity line of credit, or HELOC, is a type of home equity loan that allows you to borrow cash against the current value of your home. You can use it for all kinds of purchases up to an approved amount, so it works kind of like a credit card.
Dave Ramsey recommends one mortgage company. This one!
Also like a credit card, a HELOC uses a revolving credit line, which means that as you pay back what you borrowed, the amount you paid back becomes available for you to spend again.
With HELOCs, it’s easy to get stuck in that revolving door of credit and suddenly find yourself in a tight (even critical) financial spot—especially if you’re carrying a high balance.
HELOC vs. Home Equity Loan: What’s the Difference?
A HELOC is pretty similar to a home equity loan. The main difference is that a home equity loan allows you, the borrower, to take the full lump sum you’ve been approved for all at once rather than use the charge-as-you-go method of a HELOC.
Home equity loans are also more likely to have a fixed interest rate, so your monthly payments are more predictable than they would be with a HELOC, which usually has variable interest rates.
How Does a Home Equity Line of Credit Work?
How a HELOC works is different from a regular credit card or loan because it uses your home equity as collateral.
Your home equity is the portion of your home that you own outright (aka the difference between how much your home is worth and how much you owe on your mortgage). And collateral is the security for your loan—in other words, it’s the thing you promise to give to the lender if you can’t pay back what you owe.
Don’t miss that: A HELOC uses the part of your home that you own as collateral. That means if you can’t pay back the HELOC, the lender can foreclose on your house. Yikes!
Now you can see why we don’t recommend HELOCs—because if you get one of these monsters, you’re risking the roof over your head!
But just so you can see how it works, let’s pretend you’ve been approved for a HELOC, and your credit line is $40,000. You spend $35,000 updating your kitchen. (Hey there, subway tiles and shiplap.) Now you only have $5,000 left to use until you replace what you originally borrowed. Once you pay that $35,000 back, you have $40,000 available to spend again.
What Can You Use a HELOC For?
You can spend a HELOC on pretty much anything you want. Some common uses are:
- Home renovations
- Paying off other debt (like the mortgage, student loans, credit cards or medical bills)
- Retirement living expenses
- Buying vacation or investment properties
- Taking long periods of time off work
- Big expenses, like a wedding, college tuition or super fancy vacation
Those are some really major situations that can either be really exciting or really scary (or both). So we get why it’s tempting to take out a HELOC to try to pay for them.
The problem is, a HELOC is debt. So you end up paying for the expensive thing itself, plus thousands of dollars extra in interest. To make things even more stressful, your debt could be called in when you don’t have the money to pay it off—and that can land you in a heap of trouble (more on that in a minute).
How Long Does It Take to Get a HELOC? (And How Much HELOC Can I Get?)
Once you apply for a HELOC, it can take a few weeks to get approval.
A HELOC is a type of second mortgage, so applying for one is similar to applying for your first mortgage. Lenders will go through a formal process of evaluating your financial situation and home equity to determine if you’re a credit risk or not. They’ll look at your:
- Home’s current equity
- Home’s appraised value
- Proof of employment and income
- Credit history
- Credit score
- Outstanding debts
After verifying these things, lenders will decide how much HELOC you can get. In most cases, borrowers are approved for around 80% of their home’s equity.
Let’s say your home is worth $180,000, and you still owe $100,000 on your mortgage. You’d have $80,000 in equity you could potentially access through a HELOC. So you’d likely be approved for a credit line of $64,000, which is around 80% of your equity.
HELOC Closing Costs
Applying for a HELOC comes with closing costs, just like your mortgage did!1 And HELOCs have many of the same up-front costs as a mortgage, including lender fees.
Your lender has to process the HELOC, check your credit, appraise your home, prepare legal documents, and originate (aka open) your HELOC account. Lender fees cover those costs—plus a little extra to line the lender’s pocket.
And once you’re approved for your HELOC, continuing costs will kick in, like:
- Transaction fees: These pop up every time you borrow money from your HELOC.
- Minimum withdrawal fees: Most HELOC accounts set a minimum amount of money you can withdraw and charge a fee if you take out less. If you want to avoid the fee, you’ll have to withdraw at least the minimum amount of money, even if it’s more than you actually need—and you’ll be paying interest on everything you took out!
- Inactivity fees: If you haven’t used your HELOC for a long time (read the fine print to see how long), your lender could charge you a fee.
- Early termination fees: Your lender might require your HELOC account to be open for a certain amount of time (around 3–5 years). If you want to cancel it before then, you’ll have to pay a cancellation fee (which could cost thousands).
- Required balance: Your HELOC could have a required balance, which would mean you’d be paying a certain amount of interest on it each month whether you’re using your HELOC at the time or not.
If you decide to go ahead with a HELOC, you’ll need to read the fine print on your offer statement super closely so you can know exactly what you’re getting into. It will detail all the fees, costs and penalties you could face—and it’ll tell you how to pay back your HELOC.
How Does Paying Back a HELOC Work?
Well, it doesn’t work in your favor—that’s for sure! Lenders set up HELOC repayment plans so they can make money, not make it easy for you.
Trying to pay back your HELOC in minimum monthly payments—like most people who use credit cards or credit lines—will not fill your account back up very quickly, and you’ll end up paying even more ridiculous interest charges!
Here are some other important things to know about paying back a HELOC:
Repayment: There are a lot of different borrowing and repayment schedules for HELOCs, but most people get a long-term, 30-year repayment option. Yes, 30 years! Do you really want to spend the next 30 years of your life knowing that someone else holds the strings to your home? No, thanks!
Interest rates: Fixed-rate HELOCs are rare. So you’ll probably have to deal with fluctuating interest rates for the entire life of your credit line. Those rates are basically set by the lender, and they’re definitely not based on the market as we might be led to believe. You could find yourself paying way more interest than you originally expected.
Immediate payback: Once your credit term expires, you must pay the balance in full. The same is true if you sell your home. So if you come to the end of the 30 years (or you want to sell your house) and you owe $35,000 on your HELOC, you better be able to cough up that $35,000 immediately.
Credit freezes: Even if the loan isn’t expired, the bank can freeze your credit line in some situations, like if your home’s value drops below the amount it was appraised for when you took out the HELOC. That means you can no longer use the HELOC money you were counting on.
Is a HELOC a Good Idea?
Heck no! A HELOC is not the stress-free way to start a new chapter of your life, and it’s not a shortcut to get out of debt! And we’re hoping that by now, that HELOC-funded retirement or home remodel or whatever else you had planned doesn’t sound as good as when you first started reading.
HELOCs are not the answer to your cash-flow problem. Here’s why—and we’ll tell you the real solution.
1. You’re putting your home at risk.
Just because HELOCs seem common doesn’t take away from the fact that they can also carry serious consequences. If you default or misstep in any way, the bank could take your home! Is that new bedroom furniture you just have to have or that 10-day vacation really worth losing your home over?
2. HELOCs don’t really create cash flow.
Plain and simple, a HELOC is debt. And debt doesn’t make anything flow but tears, because the borrower is slave to the lender. Do you really want to start your retirement, marriage, career or any other big, expensive life event owing money to some company that’s just out to make a buck at your expense? We didn’t think so.
The best way to create cash flow is to pay off all your debt using the debt snowball method. You can also increase your income through a second job or smart budgeting. That will generate extra money for things like home improvements, college tuition or your kid’s wedding.
3. Saving and paying cash is way smarter in the long run.
Taking on debt of any kind robs you of true financial peace. When you lay your head on your pillow at night, what would you rather be thinking about: planning a party in your paid-for kitchen, or making payments on your new marble countertops . . . for the next 30 years?
With a Ramsey+ membership, you can get all the content and tools you need to save for the future, pay off debt fast, and build lasting wealth. You’ll still have that remodel project done in no time—but it’ll be finished debt-free!
What to Do Instead of Getting a HELOC
Okay, so we covered saving money and getting out of debt with the right tools. Want to know another way to save? Lower your monthly mortgage payment! Your mortgage is probably one of your most expensive bills, but it may not have to be so expensive.
If too much of your income is going toward your mortgage, you could consider selling your home and downsizing to one that’s more affordable. Use our mortgage calculator to see if this option is right for you!
You can also consult with an experienced financial expert to see if refinancing your mortgage is right for you. The RamseyTrusted pros at Churchill Mortgage have helped hundreds of thousands of people plan smarter and make the best mortgage decisions so they can live better.