Home Equity Line of Credit (HELOC) Pros and Cons

If you’re a homeowner planning major home improvements or looking to pay off high-interest debt and are hoping to avoid dipping into your savings, one popular option that may be available to you is a home equity line of credit or HELOC.

Think of a HELOC like a giant credit card: it lets you borrow against the equity in your home as needed over a set period, then repay it over decades. If you own a significant portion of your home, you might be able to access a substantial amount of money, often more than what you could get with a personal loan.

Unlike a personal loan, which offers a lump sum of money, a HELOC provides a revolving line of credit, allowing you to withdraw, repay, and withdraw again as needed over an extended time. Also, HELOCs usually offer better interest rates compared to personal loans and are often easier to get, even if you have bad credit.

However, there are some downsides to consider, such as variable interest rates and the potential risk of overborrowing. Opening a HELOC can be advantageous for some homeowners, but it’s important to weigh the HELOC pros and cons before making any big decisions.

How does a home equity line of credit (HELOC) work?

With a HELOC, you only repay what you actually borrow.

For instance, say you’re approved for a HELOC credit limit of $150,000. You then use $40,000 for a kitchen renovation and $15,000 for a bathroom upgrade and decide to add on a back deck for another $7,500. While your credit limit is $150,000, you’ll only have to pay back the $62,500 you withdrew from the line of credit for your home upgrades.

Also, HELOCs have two phases.

The first is the draw period, which typically lasts 5 to 15 years. During this time, you can borrow money as needed, up to your credit limit, and you’ll only be required to make interest-only payments every month (though it’s best to try and pay down the loan principal, too!).

The second is when the draw period ends, where your HELOC enters the repayment period, usually lasting 10 to 20 years. At this stage, you can no longer borrow money and must start repaying the principal and interest through monthly payments.

Pros of a HELOC

A HELOC is a convenient way to use your home’s equity for things like large renovations, debt consolidation, college expenses, and more. It has many advantages, such as lower interest rates and flexibility in borrowing and repayment.

Flexibility

HELOCs are great because they’re flexible, letting you access funds exactly when you need them and only as much as you need. Instead of getting a lump sum upfront, as you would with a home equity loan, you typically have a 5 to 10-year draw period where you can withdraw money from your HELOC over time, borrowing whenever you need, as much as you need (up to your credit limit), to cover your expenses as they arise. This way, you’re not paying interest on money you haven’t used yet.

Say you opted for a personal loan instead of a HELOC for the home upgrades we mentioned earlier. You estimated the costs, showed the bank, and were approved for the $62,500 you need for the upgrades.

Then, one year later, a major summer storm hits, knocking a tree onto your roof. Now, you need $11,000 to fix your damaged roof. Even though you’re still paying off your loan, you now have to apply for a second loan to pay for the roof repairs.

But if you had opted for a HELOC, that second loan application wouldn’t be necessary. Because you were approved for a $150,000 credit limit and you only used $62,500 for your home upgrades, you still have $87,500 available on your line of credit (assuming you hadn’t paid it down over the past year!). Thanks to your HELOC, you can easily go in and withdraw the amount for the roof repairs.

Now, instead of being possibly stuck with two loan payments, you’re just paying more monthly interest on a slightly bigger HELOC balance.

Lower interest rates

A HELOC uses your home as collateral, making it less risky for lenders compared to unsecured personal loans or high-interest credit cards.

Because of this, lenders often offer lower interest rates and initial closing costs. Getting the lowest interest rate possible can save you tens of thousands of dollars over the life of your loan.

HELOC interest rates are usually made up of the lender’s prime rate plus a fixed percentage. So, if your HELOC rate is prime + 2% and the lender’s prime rate is 5.95%, your rate would be 7.95%.

When you compare that to credit card interest rates, which can be 19.99% or higher, HELOCs generally offer more favourable rates. This is why many homeowners use their HELOC to pay off their higher-interest credit card debt.

High loan limit

With a HELOC, the amount you can borrow is based on your home’s value and the loan-to-value (LTV) ratio set by lenders. LTV measures your loan amount against your home’s value as a percentage.

Let’s say your home is valued at $500,000, and your mortgage balance is $200,000.

Lenders usually set a maximum LTV limit for HELOCs, often up to 85% or 90%. This limit impacts how much you can borrow. A higher LTV ratio allows you to borrow more against your home’s value.

Now, let’s say a lender is offering a maximum 80% LTV ratio. To find your potential HELOC borrowing limit, take your home’s value, multiply it by the lender’s maximum LTV ratio, and then subtract your mortgage balance.

• (500,000 x 0.8) - 200,000 = $200,000

A lender offering a maximum 80% LTV ratio might allow you to borrow up to $200,000 with a HELOC.

For comparison, according to the Financial Consumer Agency of Canada, most personal loans range from $100 to $50,000. This means, in this example, you have the chance of qualifying for a much larger loan with a HELOC than you would with a personal loan.

No restrictions on usage

Remember how we mentioned that one of the best things about a HELOC is its flexibility? We weren’t kidding. With a HELOC, you can use the funds however you want. Unlike personal loans that might have specific usage rules from lenders, a HELOC gives you the freedom to choose—whether it’s for home renovations, education expenses, consolidating debt, or something else entirely.

Interest-only payment option

With a HELOC, you have flexible repayment options. During the draw period, you usually only need to pay interest on what you’ve borrowed.

This can lighten your financial load in the short term, giving you more flexibility in managing your budget, especially if you have other significant expenses.

However, during the draw period, you can also choose to pay extra to reduce the principal balance if you want to pay it off faster, which is strongly recommended.

If you borrow a large amount, like $75,000, and choose to make only interest payments, your monthly payments will be much higher once the draw period ends and you start repaying the principal.

Possible tax-deductible interest

Your HELOC interest can sometimes be tax deductible; it just depends on what you use the borrowed money for. To qualify for a tax deduction, you need to use the HELOC funds for eligible purposes, like investing in a business or earning income from a property.

So, for example, if you use it to pay off your mortgage or pay off your higher-interest debts, the interest isn’t tax deductible. However, HELOC interest can be tax deductible if you:

• Borrow the money to make investment income (like dividends and interest)

• Use the money as a business loan (for buying business-related equipment, vehicles, or property)

• Use the money to make a downpayment on an investment property (such as a rental property)

Increases your credit score

Having a HELOC can be a great move because it can help increase your credit score. Adding a HELOC to your credit mix shows lenders you can handle different types of debt responsibly.

It also lowers your overall credit utilization ratio by increasing your available credit, which is a key factor in credit scores.

Plus, making regular, on-time payments on your HELOC can improve your payment history. Having a better credit score can lead to more favourable loan terms and interest rates in the future.

Cons of a HELOC

While HELOCs offer flexible and affordable ways to access cash, they also come with variable interest rates, lower your home equity, use your home as collateral, as well as other things risks to consider.

Secured by your home

Whenever you use collateral, you risk losing it if you can’t keep up with your payments. A HELOC is a secured loan, meaning it’s backed by collateral—in this case, your home.

This means that if you can’t make the payments, you risk foreclosure, which puts your financial stability and your home at risk. It’s not just your credit score on the line; your place of residence is, too.

That’s why, before you take out a HELOC, you must make sure you can afford the payments, especially the higher payments you’ll face when you enter the repayment period.

Variable interest rates

HELOC interest rates are typically variable, meaning they change based on the Bank of Canada’s overnight rate. When the overnight rate goes up or down, lenders’ prime rates adjust accordingly.

So, while a variable-rate line of credit can sometimes be better than a fixed-rate loan, especially when rates are falling, there’s a risk that a HELOC with a variable interest rate could cost you more if market rates go up.

Plus, since the interest rate can change unexpectedly, it can make budgeting for HELOC payments more difficult.

Lowers your equity

When you take out a HELOC, your home equity decreases because you’re borrowing against your home’s value. Every dollar you withdraw from a HELOC reduces the portion of your property you actually “own.”

Let’s say you owe $200,000 on your mortgage, and your home is worth $500,000; you have $300,000 in equity ($500,000 minus $200,000). If you take out a $62,500 HELOC, your equity drops to $237,500 ($300,000 minus $62,500).

If the housing market in your area declines, you might end up owing more than your home is worth.

Risk of overspending

Because a HELOC is an open line of credit, homeowners can risk overspending. Much like a credit card, you can borrow up to your credit limit, giving you access to a large sum of money.

This can be tempting and might lead to spending more than necessary, resulting in a high balance that’s difficult to pay off. It’s easy to end up owing tens of thousands of dollars, so it’s crucial to have a plan for how you’ll use your HELOC funds.

To avoid overspending, you’ll want to create a budget that’s focused on your essential expenses or investments that add value to your home and monitor your spending by setting limits.

Also, you should consider repaying the principal throughout the draw period instead of just covering the interest-only payments.

Another option is to negotiate the credit limit of your HELOC. Since your lender may approve a higher limit than you actually need, if you know there’s a good chance you’ll overspend. You can ask your lender to adjust it. This can help prevent you from borrowing more money than necessary.

Additional and ongoing fees

Having a HELOC involves ongoing fees, which add to the cost of borrowing. You’re paying extra just to have access to the funds, even if you don’t use them, making a HELOC more expensive in the long run. These fees include:

• Legal fees

• Title search fees

• Application fees

• Home appraisal fees

• Administration fees

• Closing costs

• Annual fees

• Transaction fees

• Inactivity fees (if you don’t use the HELOC for a certain period)

• Taxes

• Discharge fee

High payments in repayment period

While the cost of a HELOC is relatively low during the draw period, the repayment period can be a shock, especially if interest rates are rising.

During the draw period, you only pay interest, but once you enter the repayment period, you must start paying back both the interest and the principal.

Switching to the repayment period can significantly increase your monthly payments, especially if you only made the interest-only payments throughout the draw period instead of paying down the principal.

This significant increase is often referred to as “payment shock”, and it can put a major strain on your budget if you’re not prepared for the higher payments.

That’s why it’s crucial to plan how you will repay both the interest and principal before committing to a HELOC.

Lenders can reduce your credit limit

Canadian federal law allows the lender to reduce your HELOC credit limit in certain situations. If the bank determines, according to regulatory standards, that your property’s value has significantly declined since your HELOC was approved, they may decide to lower your credit limit.

Callable loan

A HELOC is a callable loan, meaning your lender can legally demand that you pay back the entire balance at any time, even if you haven’t missed any payments or defaulted.

However, the chances of this happening for no reason are extremely low, and it most often occurs after you’ve missed payments. Still, it’s worth mentioning because, for example, if you lose your job and your lender now considers you a higher risk of not making payments, they could require you to repay the entire loan.

Prepayment or early termination fees

Whether it’s during the draw period or shortly into the repayment period, some lenders charge a fee if you pay off and close your HELOC early. This can be an issue if you want to pay off your debt quickly instead of over a 10 to 20-year period.

Additionally, if you plan to sell your home while you have a HELOC, you might face penalties. You’ll also need to repay the full balance when the home changes ownership.

When is a HELOC the best option?

HELOCs can be a great option if you have significant equity in your home and anticipate needing cash regularly over time. However, choosing a home equity line of credit (HELOC) depends on your unique needs and financial situation. If you want to spend as needed and only pay interest on what you’ve borrowed, a HELOC is likely a better choice than lump-sum home equity loans or higher-interest personal loans.

To pay off high-interest debt

If you’re struggling with high-interest debt and can’t see an end in sight, consider using a HELOC to pay it down or even off completely. Credit card interest rates are often around 19.99% or higher, whereas some of the best HELOC rates in Canada are currently between 6.95% and 7.95% APR (depending on your credit history and other factors), meaning you’ll end up paying significantly less in interest fees with a HELOC.

To pay for major home renovations or repairs

HELOCs offer flexible funding for home improvement projects, which is especially helpful since many home renovation projects end up with unexpected costs, like outdated electrical work or bringing your home up to code. With a HELOC, you’ll likely have access to plenty of funds, so you’ll be able to withdraw more money when these unexpected costs arise.

As for home repairs, your emergency fund should cover routine fixes. However, a HELOC can be handy for major repairs, like a new roof to replace yours that was damaged in, say, a major summer storm.

To pay for major expenses

Sometimes, it makes sense to charge certain purchases to a credit card or take out a personal loan. However, for bigger expenses, using a HELOC might be a better option due to lower interest rates and more flexible repayment terms.

This can be useful for things like paying for a wedding, a big vacation, or investing in education for yourself or your kids (though student loans may be a better option here). You could also use a HELOC to pay down on vacation property.

To start a business

A HELOC can give you the seed money to grow your side hustle or cover expenses for an existing business. The interest rates on a HELOC are often lower than those on comparable business loans.

Plus, since a HELOC is secured by your home, it might be easier to get approved.

However, using your home as collateral comes with risks. If your business doesn’t succeed or you face financial difficulties and can’t keep up with payments, remember that the lender could foreclose on your home. You’ll want to strongly consider whether the lower interest rates on your HELOC compared to a business loan are worth the risk.

Alternatives to a home equity line of credit

While opening a HELOC can be a great option, there are alternatives you may want to consider first.

Home equity loans

Home equity loans are installment loans that use your home’s equity as collateral. Unlike a revolving line of credit, a home equity loan offers a fixed loan amount and a fixed annual percentage rate (APR), which is great if you value predictability.

Personal loans

Personal loans usually come with fixed APRs and don’t require any collateral. So, while you might pay a higher interest rate compared to a HELOC, you won’t have to use your home as collateral.

Personal line of credit

If you have good credit, a financial institution or lender might offer you an unsecured personal line of credit to help pay down debt or cover large expenses. It works similarly to a HELOC but won’t use your home as collateral.

Mortgage refinance

A mortgage refinance, or cash-out refinance, replaces your existing mortgage with a larger one. Closing costs come from the loan proceeds, and you can use the remaining funds as you wish.

This option typically offers lower interest rates and allows you to pay off both principal and interest over the life of your mortgage.

0% introductory interest rate credit cards

You can also use a balance transfer credit card that offers a low or 0% introductory interest rate to refinance high-interest credit card debt. Just make sure to pay off the balance during the promotional period to avoid much higher interest rates when the regular APR kicks in.

The bottom line

A HELOC can be a beneficial way to use your home equity for financial goals or large expenses. However, before opening one, it’s wise to shop around and do the math to make sure it’s the most cost-effective option for you.

And speaking of wise decisions, did you know that improving your credit score can help you secure better interest rates and a higher credit limit on a HELOC? KOHO can help with that.

You can build your credit with KOHO using the line of credit or secured line of credit credit-building options. Approval is guaranteed, and there’s no interest or application process. Making on-time payments boosts your credit score since KOHO reports to credit bureaus.

KOHO’s credit-building customers see an average increase of 22 points in their credit scores in just three months! Plus, you can monitor your credit score for free.