Best Ways to Use a HELOC

How Does a HELOC Work?

A HELOC is a revolving line of credit that lets you borrow against up to 85% of your home's equity, which is the difference between your home's value and your remaining mortgage balance.

HELOC repayment has two parts: the draw period (typically 10 years) and the repayment period (often 20 years). You'll make interest-only payments on any money you use during the draw period and start repaying your balance in full once the draw period ends. During the repayment phase, your payments are likely to increase substantially, so it's critical to plan ahead. If you are unable to make payments at any point during the life of your HELOC, you could be at risk for foreclosure.

Most HELOCs have variable interest rates and a rate cap. Closing costs on a HELOC average between 2% to 5%.

Best 5 Ways to Use a HELOC

HELOCs offer the benefit of high lending limits and flexibility. They generally have lower interest rates than other borrowing options, but they also require you to use your home as collateral. The best uses for a HELOC account for both their benefits and risks. Here are five of the best ways to use a HELOC.

1. Improve Your Home

HELOCs provide flexible funding for home improvement projects. This can be especially useful if your project will roll out in stages or may have hidden costs (such as surprise termite damage or electrical work that isn't up to code). A HELOC gives you access to ample funding, but you'll only draw money as you need it.

There's an added tax benefit if you itemize your deductions: Interest on your HELOC may be tax-deductible when funds are used to "buy, build or substantially improve" your home. You'll need to meet IRS requirements for claiming home mortgage interest deductions, but could lower your net costs with tax savings.

2. Do Major Home Repairs

Your home maintenance budget or emergency fund should cover the cost of routine fixes. But a HELOC can help you pay for major repairs, like a new roof. If repairs add to your home's value, the interest on your HELOC may be tax-deductible as well. Because the line between a substantial improvement and a regular repair can be blurry, you may want to consult with a tax pro to make sure your expenses qualify.

3. Get Ready to Sell

If your home needs some sprucing up before it goes on the market, a HELOC can help cover the costs of new landscaping, HVAC upgrades or other improvements that help you fetch top dollar. As a bonus, you may be able to pay off your HELOC using proceeds from the sale.

4. Consolidate or Pay Off Debt

You can save money on interest charges and consolidate bills by using a low-interest HELOC to pay off high-interest credit card debt. You may even boost your credit score in the process: Because a HELOC doesn't count as revolving credit when calculating your credit score, consolidating your debt this way could improve your credit utilization ratio and your credit score.

A word of caution, however, is that this should only be done if you have a solid plan to pay off the debt without taking on new debt. Zeroed out credit card balances may tempt you to spend, and because your home secures your HELOC, falling behind on payments could put your home at risk.

5. Bolster Your Emergency Fund

Keeping a line of credit in reserve gives you an additional line of defense when you're going through a financial crisis. Whether you face a major unexpected expense or a sudden period of unemployment, you'll have a ready supply of cash if your emergency fund falls short.

When Not to Use a HELOC

While you can use a HELOC to fund almost anything, you may not want to tap your home's equity or put your home at risk of foreclosure if other sources of financing might be a better fit. Here are a few times to think twice before using a HELOC.

Discretionary Spending

A line of credit isn't a substitute for budgeting and saving. Tapping home equity to pay for regular expenses (even in retirement) or big-ticket items like weddings and vacations isn't a good long-term strategy: You'll be moving away from owning your home, not toward it, and putting your home at risk in the process.

Buying a Car

Even in a high-interest-rate environment, you'd likely be able to find a car loan with an APR that's comparable to a HELOC if you have good credit. More importantly, your loan will be secured by your car instead of your home.

Paying for College

If you need to finance college tuition and expenses, you may want to explore student loans. Federal student loans have relatively low interest rates and offer some protections, such as loan deferment, forbearance, forgiveness or income-based repayment plans. Students may also want to consider applying for scholarships, choosing a more budget-friendly school or starting out at community college to save money.

Covering Medical Debt

While you may ultimately want to use a HELOC to finance medical debt, first contact your health care provider and insurance company to make sure you've received the coverage you're entitled to. You may also be able to negotiate your medical bill, set up a direct payment plan or qualify for financial assistance.

Starting a Business

New businesses can be risky. If your business fails—or even falters—you may not be able to pay back your loan, with your home hanging in the balance. Instead, consider an SBA or business loan, crowdfunding, finding investors or using credit cards if possible.

Investing

Although you may be able to use funds from a HELOC to buy investments or an investment property, be careful about over-leveraging. If your investments go south, you could lose your investment and your home.

Is a HELOC a Good Idea?

A HELOC can be a great choice if you plan to repair or renovate your home, or want to use a lower-interest HELOC to consolidate high-interest debt. A HELOC can also work as an emergency funding resource, whether you're facing financial struggles now or want to keep funds in reserve for the future.

Because a HELOC taps your home's equity, it's not always the best option. If you're planning a big expense like a wedding, buying a car, financing college or starting a business, finding a loan that's more suitable for your funding needs will keep your home equity intact—and help you avoid putting your home at risk of foreclosure.

Alternatives to HELOCs

If you need to finance a major purchase, create a line of credit to cover upcoming or unforeseen expenses, or refinance debt, consider these choices.

• Home equity loan: Home equity loans are installment loans that use your home's equity as collateral. A home equity loan doesn't have the flexibility of a revolving line of credit, but it can provide a fixed loan amount and fixed annual percentage rate (APR), if predictability is your priority.
• Cash-out home refinance: Instead of adding a second mortgage, refinance to a larger loan and receive the difference in cash. A cash-out refinance typically makes the most sense when interest rates are low (or at least lower than they were when you got your original loan). Also beware: A refinance resets the clock on your mortgage, extending the time you'll need to pay off your home.
• Personal loan: Personal loans typically offer fixed APRs and require no collateral. You may pay a higher rate than you would on a HELOC, but you won't use your home to secure the loan. Personal loans are available for up to $100,000. Experian can help you find loans that fit your credit profile.
• Personal line of credit: If your credit is good, your bank or credit union may offer you an unsecured personal line of credit you can use to pay down debt or finance large expenses. Unlike HELOCs or personal loans, personal credit lines count toward credit utilization in figuring your credit scores.
• Balance transfer credit card: Refinance high-interest credit card debt with a balance transfer card that offers a low or 0% introductory interest rate. Pay off your balance during the promotional period to avoid paying higher interest when the card's regular APR kicks in. You'll need good credit to qualify.
• Reverse mortgage: If your home is paid off or nearly paid off, a reverse mortgage provides you with regular payments based using your home's equity as collateral. You don't make payments on a reverse mortgage. Instead, you pay off your loan balance when you sell your home. Reverse mortgages require homeowners to be 62 years of age or older to take part.

The Bottom Line

HELOCs have unique benefits: lower interest rates, funding flexibility and a potential tax deduction, to name a few. However, using your home as collateral is serious business. If your income fluctuates or you're otherwise at risk for not being able to repay your loan, proceed with caution.

To qualify for a HELOC, you'll need a good credit score and significant home equity. Checking your credit report and credit score proactively can help you sort out your loan options and decide whether a HELOC is the best fit for you.