Mortgage Basics

The Pros and Cons of HELOCs: What's the Smartest Move?

The Pros and Cons of HELOCs: What's the Smartest Move?
Written by
  • Ashley Howard
| 18 September 2023
Reviewed, 18 September 2023
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    A Home Equity Line of Credit (HELOC) is a financial product that allows homeowners to access up to 65% of their home’s equity. It provides a flexible source of funds that can be used for various purposes, such as home improvements, debt consolidation, or emergency expenses. 

    HELOCs have pros and cons, like any financial product, and won’t be suitable for everyone. In this blog post, we will explore the advantages and disadvantages of having a HELOC and discuss the smartest way to manage the revolving portion of the loan when considering this option.

    Key Takeaways

    • A HELOC allows you to access up to 65% of your home equity quickly and easily when needed.
    • HELOCs reduce your risk to lenders since they use your home as collateral. They can offer better interest rates than personal loans, credit lines, and credit cards. 
    • With HELOCs, it’s important to borrow responsibly to ensure you can pay off the debt without risking your home.

    Understanding the Pros of HELOCs

    Home Equity Lines of Credit have several advantages that can make them an attractive choice for homeowners seeking additional funds. HELOCs allow homeowners to leverage their biggest asset, their home. By using the equity in your home as collateral, you can access additional credit, which can help fund other significant expenses. Some of the advantages of having a HELOC include: 

    Ease of Access

    Once you have equity, the money is always there and easily accessible. This allows you to access the funds available whenever needed rather than applying and being approved for credit each time.

    Flexibility 

    HELOCs allow homeowners the flexibility to borrow funds as needed, similar to a credit card. Some mortgage lenders may even offer their HELOC attached and accessible through a Visa or Mastercard. This flexibility enables you to access funds up to your limit whenever required. 

    You’ll pay interest only on the amount used and can repay the money without prepayment penalties. Unlike mortgages, which have their interest compounded semi-annually or monthly, all types of secured (HELOCs) and unsecured have daily compounding on the interest charged on the amount owing at the end of your statement cycle.

    Borrowed funds can be used for almost anything from renovating your home to paying for your children’s education, consolidating high-interest debts, purchasing a second home, or as backup for any emergency expenses. 

    Lower Interest Rates 

    HELOCs often have lower interest rates on their revolving credit components than other borrowing forms, such as credit cards or personal loans. This can result in significant savings on interest payments, especially if used for large expenses.

    Tax Advantages 

    In some cases, the interest paid on the revolving portion of a HELOC may be tax-deductible if the funds are used for investments that generate income (sometimes known as the Smith Manoeuvre ). This can provide additional financial benefits for homeowners. 

    However, this strategy can be risky depending on interest rates and the investments chosen. It’s always recommended that you consult a financial or tax expert to ensure that any tax-advantageous strategies meet the CRA’s guidelines. 

    Exploring the Cons of HELOCs

    HELOCs offer homeowners a flexible and convenient way to tap into their home’s equity, providing a valuable source of credit. It’s equally important to consider the potential drawbacks before considering this option. Some of the disadvantages of having a HELOC include:

    Variable Interest Rates 

    Unlike fixed-rate loans, the revolving portion of HELOCs often comes with a variable interest rate. This means that your monthly payments could fluctuate based on market conditions. Rising interest rates can result in higher monthly payments, making it difficult to manage your finances.

    The Temptation to Overspend 

    The flexibility of a HELOC can lead to overspending and accumulating more debt than initially intended. It’s crucial to have a disciplined approach when accessing the equity in your home and use these funds responsibly to avoid financial pitfalls.

    Paying off a HELOC requires discipline since you’re only required to pay the interest compounded daily but charged monthly. This makes it easier to carry a larger amount of debt for a longer period of time. 

    Risk of Loan Default 

    Since HELOCs are secured by your home, failure to make payments can put your mortgaged property at risk. It’s important to consider your ability to repay the borrowed funds before taking out a HELOC and ensure you are not overleveraged.

    Factors to Consider Before Getting a HELOC

    HELOCs can be a valuable resource for homeowners, allowing them to leverage their home’s equity for various financial needs. However, before applying, several factors need to be considered. 

    Evaluating your financial situation and repayment capabilities is important since a HELOC uses your home as collateral. You must be confident in your ability to make the necessary repayments, as defaulting could lead to the loss of your home. 

    Here are a few things to consider when determining if a HELOC is suitable for you:

    • Purpose of borrowing: Before obtaining a HELOC, evaluate your reasons for borrowing. Prioritize using the funds for expenses that add value to your financial situation, such as home improvements or education.
    • Repayment plan: Develop a solid repayment plan to ensure you can comfortably make repayments and work toward paying off the balance. Consider how changes in interest rates could affect your ability to repay the borrowed funds.
    • Market conditions: Keep an eye on market trends and interest rate forecasts. If interest rates are expected to rise significantly, it may not be the ideal time to take out a HELOC or use any equity you have in one to fund purchases that won’t add value.

    How to Make the Smartest Financial Move with a HELOC

    Making smart financial moves with a HELOC requires careful planning and strategic thinking. This begins with understanding your financial needs and identifying the right time to utilize the funds. If you fail to repay the loan, you could lose your home. It’s essential to borrow only what you need and are confident you can repay. 

    • Borrow responsibly: Only borrow what you need and can afford to repay. Avoid the temptation to use the entire available credit line unless necessary.
    • Shop around for the best rates and terms: Compare offers from different lenders to secure the most favourable interest rates, repayment terms, and fees. Pay attention to details such as introductory rates, annual fees, and any renewal or prepayment penalties.
    • Consult a financial professional: Seek guidance from a financial professional who can help you analyze your financial situation and determine if a HELOC is the right choice.

    Tips for Managing and Maximizing a HELOC

    When used responsibly, a HELOC can be a valuable financial tool. To manage and maximize this tool effectively, here are some essential tips you should follow: 

    • Keep track of your spending: Maintain a budget and track your expenses to ensure you spend wisely and avoid overspending or accumulating unnecessary debt.
    • Make timely payments: Make payments on time each month to avoid late fees and potential damage to your credit score. Automating more than your minimum payment on a biweekly frequency can help you avoid this problem.
    • Consider making additional payments:  Instead of only paying the interest, make payments toward some of the balance to reduce the overall interest you will pay. If you have extra funds, consider making additional payments towards your balance to further reduce the amount and save on interest charges. 

    Alternatives to HELOCs for Accessing Home Equity

    If you’ve determined that a HELOC may not be the right solution for you, there are some alternatives that will allow you to access your home equity worth exploring. 

    Home equity loans are similar to HELOCs, allowing you to borrow against your home equity. The difference is that they provide a lump sum amount, usually with a fixed interest rate and monthly payment, and have higher interest rates than a mortgage.  

    Cash-out refinancing, better known as equity take out (ETO), involves breaking your current mortgage and paying off the balance using another mortgage of a higher amount. This allows you to access the equity in your home as collateral for the higher loan. The new mortgage will have a higher principal, and you will receive the difference in cash.

    The Impact of HELOCs on Credit Scores

    HELOCs can both positively and negatively impact your credit score. The total impact, however, will vary depending on how well you manage debt and your existing credit file.

    Opening a HELOC can initially have a minor negative impact on your credit score. This is due to a new hard credit inquiry for qualification and the potential decrease in the average age of your collective credit accounts. 

    If managed responsibly, a HELOC can help improve your credit score as you consistently make timely payments. This gives you an additional product on your credit file that reflects a positive repayment history while diversifying your credit mix. 

    Common Mistakes to Avoid when Using a HELOC

    Since a HELOC gives you easy access to large amounts of money, borrowers often make many common mistakes, which can lead to significant financial distress. 

    Using your HELOC for non-essential or discretionary spending that won’t contribute to your long-term financial goals and health should be avoided. Ignoring your repayment obligations and failing to make timely payments can result in late fees, damage to your credit, or the risk of losing your home. 

    Additionally, relying solely on your HELOC for emergency funds should be avoided. It’s advisable to have a separate emergency fund in addition to a HELOC to cover any unexpected expenses so you aren’t relying solely on credit for emergencies. 

    Frequently Asked Questions

    What is a HELOC?

    A HELOC is a secured form of revolving credit using your home as collateral. You can borrow up to 65% of your home’s purchase price or market value if your HELOC is combined with a mortgage. However, your outstanding mortgage balance combined with a HELOC cannot exceed 80% of your home price or market value.

    How is a home equity loan different from a mortgage?

    A home equity loan is typically not at the same lender as your mortgage and doesn’t hold as secure of a position when compared to a mortgage. Lenders will charge higher interest rates for the higher risk which they take on compared to a first or second mortgage on the same property.

    Does a home equity loan hurt your credit?

    A home equity loan or line of credit can positively or negatively affect your credit score, depending on how you use it. If you are utilizing the loan responsibly and making payments on time and consistently, you’ll see an increase in your credit score. However, exceeding more than a third of your total credit limits could negatively impact your score as it will affect your utilization ratio used when calculating your credit score.

    Final Thoughts: Making an Informed Decision About HELOCs

    A HELOC can be a valuable financial tool for homeowners, providing flexibility and easy access to funds when needed. However, carefully consider the pros and cons, evaluate your financial situation, and have a well-defined repayment strategy before you start using it. 

    You can assess whether a HELOC is a smart move for your circumstances by following the tips provided in this post. Are you looking for customized advice? Let us help you compare and save when shopping for your mortgage.