For many people, a home is their most valuable asset. Yet some homeowners may be unaware of different products that help consumers access the equity they've built up in a home after years of monthly payments on a mortgage.
A home equity line of credit (HELOC) offers homeowners a way to tap into that equity for cash. Whether you need funds for a home project, a new kitchen appliance, a school tuition payment, emergency personal expenses or to pay off credit card debt, a home equity line of credit can help you meet your financial needs.
As the name implies, a HELOC is a line of credit, similar to the credit cards in your wallet. However, there are important differences between the two. Understanding these points of separation can help you judge whether a HELOC or a credit card is right for any one particular situation.
In some cases, a HELOC is more advantageous than using credit cards — like when interest can be written off. In other instances, a credit card may be best-suited.
To help you make more informed financial decisions, let's explore what HELOCs are and how they stack up against credit cards.
A HELOC is a revolving line of credit, similar to credit cards. What is revolving credit? It is a credit line that allows you to continuously borrow up to a maximum limit. You pay the money back over time, often by making minimum payments, which are determined based on how much of credit has been accessed.
At a high level, some of the benefits of a HELOC include:
- Flexibility to use the funds for whatever reasons you deem appropriate.
- Potential tax benefits depending on how you use the funds.
- Lower borrowing costs compared to other revolving lines of credit, like credit cards.
- Simplified access to funds; financial institutions often provide HELOC owners with checks or a card tied to the HELOC account for efficient transactions.
HELOCs are a form of secured debt. This refers to a debt that is secured by some other form of collateral. In the case of a HELOC, your home secures the line of credit, which enables financial institutions to offer more favorable terms, like lower interest rates. There is a trade-off to this arrangement, however. If a secured debt is defaulted on, the financial institution is within its right to repossess that collateral, i.e., the residence attached to a home equity line of credit. Comparably, an unsecured debt, such as a personal loan, may come with a higher interest rate because the financial institution does not have a means to recover its investment.
The bottom line is that a HELOC allows you to borrow against your home equity up to a certain limit. This maximum amount is determined by a couple of variables, including your level of home equity. To calculate that figure, take the current value of your home and subtract how much you owe on your mortgage. Keep in mind that lenders typically only allow borrowers to access 80 - 85% of that total.
Also, HELOCs typically feature a variable interest rate, meaning your rate will increase or decrease each time it's rebalanced. These movements are influenced by the overall market for interest rates and monetary policy enacted by the Federal Reserve, which controls the federal funds rate. However, some lenders make fixed-rate options available — including Comerica Bank. Our fixed-rate HELOC allows borrowers to convert any portion of their variable-rate loan into a fixed-rate payment during the draw period (more on that below). While fixed rates may lead to higher monthly payments, they are consistent and easily budgeted for.
One note to keep in mind is that if you sell your home, your HELOC needs to be paid off regardless of where you are in the term.
While they are related products, HELOCs and home equity loans have major differences. Whereas a HELOC is a revolving line of credit, a home equity loan is a type of installment credit. An installment account enables consumers to borrow a certain amount and pay it back over a predetermined period through fixed monthly payments. Examples of installment credit include student loans, auto loans and mortgage loans.
As explained, homeowners with a HELOC can draw on the credit line continuously, paying back principal and interest over time. A home equity loan, on the other hand, advances a lump sum to the borrower.
While both allow homeowners to borrow against equity, a loan advances you a lump sum and you need to pay interest on that entire amount. When you have a HELOC, you only pay interest on the funds that you draw, not on the entire balance you've been approved for. The potential interest cost savings that a HELOC offers, compared to the lump sum option, are enticing for many homeowners.
Though they are both revolving forms of credit, HELOCs and credit cards are structured in very different ways.
A HELOC is divided into two phases: the draw period and the repayment period:
- The draw period is the time during which you can draw down on your credit line. These periods often last 10 years, though terms vary from lender to lender. Your available credit is replenished throughout this time as you pay back what you've drawn. Some lenders only require that principal payments are made during this time.
- What follows is the repayment period. This is when your home equity line of credit is no longer active and cannot be drawn upon. At this juncture, borrowers must repay principal and interest for any outstanding balances. Typically, this period lasts 20 years, which gives homeowners more time to pay off debt.
Comparably, credit cards are open-ended lines of credit that do not have draw or repayment periods. But that's not the only point of separation between these lines of credit:
- Credit cards often feature higher interest rates than HELOCs. This is because HELOCs are secured debt and credit cards are unsecured debt.
- Neither a HELOC nor a credit card are money for free, as each comes with its own costs. Some HELOCs, for example, are a bit like mortgages in that they have closing costs. Many credit cards have annual fees, but not all of them.
One thing that both have in common is that closing the line of credit might affect your credit score. Credit history length is a factor in determining your credit score, and if you close an account, it could impact the overall age of your credit, which may reduce your credit score. This result isn't a guarantee, however; and in any case, HELOCs are designed to end at a certain point. The best way to protect against a credit score decrease is to keep your credit history length at an ideal level. This may mean electing not to close other credit accounts around when your HELOC is slated to end.
Given that HELOCs and credit cards work similarly, it can be difficult to decide when either is the best option for a particular use. This may especially be the case if you can pay off a HELOC with credit cards, or consolidate credit card debt with a HELOC.
Need some insight on when to use a HELOC and when to use a credit card? Here's some guidance to help you make your choice:
You can't deduct interest paid on a credit card from your taxes. However, you might be able to deduct interest paid on a HELOC in some cases if certain conditions are met, which is a big advantage.
According to the IRS, Americans can deduct interest incurred through a home equity line of credit, among other types of home-related debt, when the funds are "used to buy, build or substantially improve the taxpayer’s home that secures the loan." From 2018 to 2026, taxpayers can deduct interest on up to $750,000 of qualified residence loans, a category that includes HELOCs. The limit is $375,000 for a married taxpayer filing a separate return.
Prior to the Tax Cuts and Jobs Act, interest could have been deducted on HELOC debt even if funds weren't used toward the home. That stipulation has been suspended from 2018 to 2026, but the tax incentive is still a powerful one, especially when you're considering a major remodel or renovation.
Home improvements are beneficial for many reasons: They can make your home more stylish or comfortable to live in, plus they can add to the home's resale value if you decide to move.
The cost of the project will likely determine if you use a HELOC or credit card. For example, if you're considering an addition or total kitchen remodel, the large cost may make a HELOC your best option. Unless you have immediate cash reserves to pay down the balance on a credit card, you could be stuck paying off the initial charge and the associated interest for a long time. Remember, home equity lines of credit often have 20-year repayment periods and HELOC interest rates are generally lower than credit cards.
The ability to deduct HELOC interest when funds are invested into the home makes such lines of credit the ideal solution for many homeowners — given credit card debt cannot be deducted. However, it is possible to open a new credit card and use it to pay for a home project while the introductory rate offer is active. Still, there are risks to this arrangement, especially if you cannot pay back a large cost before the rate reverts upward.
Some home projects to consider funding with a HELOC include:
- Minor kitchen remodel: Average 2020 national cost of $23,452/ average national resale value of $18,206/ 77.6% of costs recouped, according to Remodeling Magazine™.
- Vinyl window replacement: $17,641/ $12,761/ 72.3%
- Vinyl siding replacement: $14,359/ $10,731/ 74.7%
- Wood deck addition: $14,360/ $10,355/ 72.1%
One common use of HELOC funds is to consolidate credit card debt or pay off other high-interest debts.
As mentioned, HELOCs traditionally carry lower interest rates than credit cards and other similar lines of credit. This is an advantage for homeowners who are currently trying to pay down debts. The strategy is almost similar to using a balance transfer to pay one credit card by opening another with a 0% introductory rate. In the same vein, homeowners could open a HELOC to consolidate their credit card debt, freeing them from high-interest debt and giving them decades to pay off the principal and interest costs. In reality, a HELOC can be used to pay down any debt — e.g., student loan, personal loan, auto loan — with an interest rate higher than the HELOC.
"Can you pay off a HELOC with a credit card?" is an intriguing question. In the same way that you might use a HELOC to pay off your credit card debt, you could also potentially use a credit card to pay off HELOC debt.
This strategy may be useful if you're late in your repayment period and still have a considerable amount to pay off. Remember, if you default on a HELOC, your lender has recourse to repossess your home. If you're worried about that prospect, you may want to open a new credit card with a 0% introductory rate and initiate a balance transfer of sorts.
However, this tactic might not be right for everyone. You need to be confident that you can pay off that transferred debt before the credit card's interest rate goes from zero to double-digits once your first year is finished.
There are few restrictions to how you can use a HELOC. So while you might not be able to deduct interest when using it for non-home reasons, that doesn't mean a HELOC is any less advantageous compared to a credit card, especially when considering HELOC interest rates are often lower, on average.
There are a number of ways to smartly use a HELOC, including:
- To make a big-ticket purchase, such as a new appliance, furniture, entertainment system or recreational installation (like a pool table).
- To finance a wedding by paying vendors or renting a space, or to use as supplemental funds.
- To pay for higher education, whether spent on tuition, fees, room and board, required materials (e.g., textbooks and technology), meal plans and living expenses.
- To consolidate high-interest debt, like balance transfers from credit cards.
- To take a dream vacation without having to break the home budget.
- To fund a startup business or otherwise invest in different assets that will generate returns.
- To meet unexpected expenses, like for car repairs or medical bills.
There is an argument for each of these use cases, but it's important to use discretion when drawing on your HELOC. Although it works like a credit card, you absolutely do not want to treat it like a credit card.
Why? Remember, a HELOC is secured by your home. If you default, your home may be at risk of foreclosure. Credit cards are unsecured debt, meaning no collateral is put up. However, if you don't make credit card payments, your creditor can still place your account in collections.
The main lesson is to not rely on a HELOC to fund everyday life. This can quickly lead to living outside your means. If you depend on HELOC funds for regular transactions or monthly bills, it could imperil your homeownership as you continue to draw on your HELOC for nonessential purchases or costs. In such cases, it's best to use a credit card to pay for lunches and other everyday expenses that you can repay without having to carry a balance or put your homeownership at risk.
One instance in which you may want to use a credit card over a HELOC is if you need access to money quickly.
While you should always conduct personal due diligence before opening a new credit card, the process of doing so is relatively streamlined. Consumers with good credit scores often receive credit solicitation offers from trusted and well-known lenders. If you're pre-approved for a certain credit amount, it often only takes a few verification and setup steps before you can begin using the card.
If you need to pay emergency costs that materialize, you could be waiting much longer for a HELOC to be finalized. In such cases, an existing or new credit card could offer you more flexibility in meeting immediate needs, such as home repairs or displacement costs due to a severe storm.
Just be careful when applying for and opening new credit cards. Each time you do so, your credit score will be impacted because of the hard inquiry. It may take longer for your credit score to recover if you have too many open accounts, as well.
With a HELOC, the process is a little more involved, making it less suitable for emergency expenses. First of all, you need to have sufficient home equity before applying for a HELOC. Lenders often prefer to work with homeowners who have at least 20% home equity. If your mortgage is still young, you may not have enough equity to tap when you need it for emergency costs.
The qualification process also takes into account your credit score, debt-to-income ratio, current liabilities, other home-secured debt and additional factors. Finally, there are closing costs for every HELOC, which may come as a surprise to some. If you don't budget accordingly for these costs, your financial plans may need to be adjusted at the last minute.
There are numerous ways in which a HELOC can be used, including many instances where it makes more sense than a credit card or home equity loan. Whether you're considering adding onto your home, consolidating high-interest debt or financing a much-needed washer and dryer upgrade, a HELOC could be your best option.
If you're interested in learning more about how you can tap into your equity, reach out to Comerica Bank for more about our HELOC products and services. We offer both variable- and fixed-rate HELOCs with flexible terms and interest-only payments.
Contact us today for more information about interest rates and other specifics.