HELOC Pros and Cons: A Guide to Using Home Equity Wisely in 2024

Using a Home Equity Line of Credit (HELOC) to access cash can be a powerful financial move, but it fundamentally involves using your home as collateral. Based on our experience assessment, a HELOC is most justifiable for home improvements that increase your property's value, while using it to pay off unsecured debt or cover daily expenses introduces significant risk to your homeownership.

With home equity reaching record levels in many U.S. markets, understanding the responsible use of this resource is critical. This guide examines the strategic advantages and potential pitfalls of HELOCs to help you make an informed decision.

What is a HELOC and How Does It Work?

A Home Equity Line of Credit (HELOC) is a revolving line of credit, similar to a credit card, that uses your home’s equity as collateral. Your equity is the difference between your home’s current market value and the amount you still owe on your mortgage. For example, if your home is worth $500,000 and your mortgage balance is $300,000, you have approximately $200,000 in equity. Lenders will typically allow you to borrow against a percentage of that equity, often up to 85% of your home’s value when combined with your first mortgage, known as the Combined Loan-to-Value (CLTV) ratio.

When Does a HELOC Make Financial Sense?

Financial experts generally agree on one optimal use for a HELOC: investing in your home.

• Home Improvements and Repairs: Using a HELOC for renovations like a kitchen update or a new roof is often a sound strategy. The interest you pay may be tax-deductible if the funds are used to "buy, build, or substantially improve" the home that secures the loan (consult a tax advisor for your situation). Importantly, these upgrades can simultaneously increase your home's value, making it a potentially worthwhile investment.
• Strategic Financial Planning: For homeowners with a stable income, manageable debt, and plans to stay in their home for the foreseeable future, a HELOC can offer a lower-interest alternative for major, planned expenses.

What Are the Risks and When Should You Avoid a HELOC?

The primary risk is that a HELOC is a secured loan. Your home is the collateral, meaning failure to make payments could lead to foreclosure.

• Paying Off Unsecured Debt: While using a HELOC's lower interest rate to pay off high-interest credit cards may seem smart, it transforms unsecured debt into debt secured by your home. If a financial crisis occurs, credit card debt can lead to damaged credit, but HELOC debt can lead to the loss of your home.
• Covering Daily Expenses or Cash Flow Problems: A HELOC is not a solution for ongoing budgetary shortfalls. It can create a dangerous cycle of debt, especially because most HELOCs have variable interest rates. A low introductory rate can rise significantly over time, increasing your monthly payments.
• Beware of Introductory "Teaser" Rates: Lenders may advertise very low initial rates to attract borrowers. It is crucial to understand the fully-indexed rate—what the rate will be after the introductory period ends—and how much your payment could increase.

How Do You Determine if You're a Good Candidate for a HELOC?

To qualify for a HELOC, you need substantial equity and a strong financial profile. Lenders will look for:

• Significant Home Equity: Most lenders require you to maintain at least 15-20% equity in your home after the HELOC is opened.
• A Strong Credit Score: A good credit history is essential for qualifying for the best rates.
• A Stable Debt-to-Income (DTI) Ratio: Lenders need to see that you have sufficient income to manage the new payment alongside your existing debts.

The most critical step is to have a clear, disciplined plan for the funds and a reliable strategy for repayment. Using a HELOC should be a deliberate financial decision, not a reaction to a temporary promotional offer.

Before applying, assess your long-term financial stability and have a specific, value-adding goal for the funds. Using your home’s equity for unnecessary consumption or to mask underlying budget issues is a high-risk strategy that jeopardizes your most important asset.