5 Times a HELOC isn’t the Best Financing Choice for Homeowners

Table of Contents

1. What is a HELOC?
2. 5 Times a HELOC May Not Work for Homeowners[+]
   1. Your Next Project or Repair is a Minor
   2. You Have Bad Credit
   3. You’re a New Homeowner
   4. Your Debt-to-Income Ratio is High
   5. You’re Offered a Variable Interest Rate
3. The Takeaway

Do you want to add an addition to your home? Maybe you’ve been thinking about building a detached garage with an upper apartment to rent. Or perhaps you have plans to switch to energy-efficient windows. These big renovations come with appropriately large price tags.

Most homeowners can’t finance them on their own. Instead, they take out a Home Equity Line of Credit (HELOC) for help.

This financing taps into your home equity to offer large sums of money. It can be a convenient way to fast-track your renovation plans, but its size, terms, and conditions make it a unique borrowing option. It might not always be the right choice for your next repair or project.

What is a HELOC?

A Home Equity Line of Credit is a secured loan, as it uses your home as collateral. In other words, your lender holds your home as a guarantee that you’ll pay back what you owe on time. If something catastrophic stops you from repaying your HELOC, your lender is within their rights to take your home as payment if you stop paying back what you owe.

Technically, your HELOC is secured by the equity in your home. Equity represents the amount of your home’s current market value that you actually own. In other words, it’s the portion of your mortgage that you have paid.

You can calculate the equity you have by subtracting your remaining mortgage from your home’s value. What’s left is what you own in equity. This number determines how much you can borrow with a HELOC. In most cases, lenders let you borrow up to 80% of your equity.

Other than that, HELOC performs a lot like any other personal line of credit, in that you will receive a maximum borrowing limit. You can make draws against this limit, pay it back, and reborrow up to this limit again and again on a revolving basis.

5 Times a HELOC May Not Work for Homeowners

While a HELOC can be helpful, you might want to rethink applying for one under the following five conditions.

1. Your Next Project or Repair is a Minor

If you have a minor project or repair that requires funding, a HELOC may not be the most cost-effective solution.

When opening a HELOC, you’ll have to cover appraisal fees and closing costs, which — as a percentage of your large borrowing amount — can outweigh the price tag for smaller projects, like a new couch or building a small deck. In such cases, it may be more practical to use other financing options, like a personal loan or line of credit.

Depending on how much equity you have available, you could borrow hundreds of thousands of dollars.  As a result, a HELOC is best used for enormous household renovations, like adding an addition or replacing all your appliances.

1. You Have Bad Credit

Your home’s available equity isn’t the only factor of a HELOC. Many lenders will assess your credit history to determine if you qualify for one of their HELOCs.

While a bad credit score may not prohibit you from qualifying for a HELOC — your house acting as collateral increases your eligibility — there’s still a good chance it affects your selection. You may have fewer options than people with excellent credit because a low credit score identifies you as a risk to lenders. Many lenders raise their rates and finance charges to offset this risk.

Waiting to take on a big renovation until you improve your score may help you reduce the costs of borrowing. Take a look at these tips to learn how you can boost your score quickly.

2. You’re a New Homeowner

If you purchased your house within the last year or so, the ink on your mortgage is practically still wet. With such a new mortgage, you still likely owe the majority of the sale price for which you purchased your property.

Remember that equity is the difference between your home’s value and what’s left on your mortgage. When you still owe your entire mortgage, you don’t possess any equity at this point. In other words, there’s no equity for you to leverage into a HELOC.

Every lender will set its own policies, but it’s not unusual for a lender to require you to hold at least 20–25% equity in their home. You might have to wait a couple of years while consistently paying your monthly mortgage until you qualify.

3. Your Debt-to-Income Ratio is High

A HELOC is like any other borrowing option available today. It only makes sense when you have the budget to juggle its payments and all your essential expenses. A high debt-to-income ratio can throw doubt on your ability to multi-task with your finances.

Debt-to-income (DTI) shows the percentage of your take-home pay goes towards debt. Generally speaking, financial advisors recommend keeping this rate below 40%.

Borrowing with a higher DTI than that may affect your candidacy. Lenders that check this stat when assessing your eligibility may reduce how much they’re willing to lend you. They may even deny you outright.

Borrowing with a high DTI is risky, even if your lender doesn’t think so. A high DTI means the majority of your take-home pay is already going to existing debts. Adding another can put pressure on your budget. Under those conditions, a family emergency or unexpected expense may have the power to snap your budget in two.

4. You’re Offered a Variable Interest Rate

Most HELOCs come with variable interest rates. This means the interest you pay day-to-day will fluctuate according to the markets.

Some people feel comfortable with this variability. However, accepting variable rates can mean your payments change drastically from month to month. It can be hard to budget these payments when you don’t know what to expect.

Other people are willing to gamble on the markets. The prime borrowing rate is high right now to combat runaway inflation, but economist forecasts these rates will drop soon. People who accept variable rates may do so assuming they’ll cash in when the prime rate decreases. However, they run the risk of dealing with climbing rates in the meantime.

The Takeaway

You might want to think carefully about borrowing a HELOC if:

• You need help financing small repairs.
• You have a subprime credit score.
• You don’t have enough equity available.
• You have a lot of outstanding debt.
• You are offered a variable rate.

While these reasons aren’t enough to swear off HELOCs altogether — leveraging your equity can be a financially savvy option in certain situations — they should flag your attention. Take the time to compare your other options to ensure you find the best financing for your home.

Thank you for reading!