5 Questions to Ask Before Applying for a HELOC

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You've paid enough on your mortgage to build a solid amount of equity in your home. Now you want to tap into it; maybe you want to use the money to pay off high-interest credit card debt, help fund a child's college education, or take on a major kitchen remodel.

You have two choices when it comes to using that equity: a home-equity loan or a home equity line of credit. These are two very different options, but many homeowners prefer the flexibility that comes with a home equity line of credit — better known as a HELOC — instead of the lump-sum payment they get with a home-equity loan. (See also: Home Equity Loan or HELOC: Which Is Right for You?)

But before you apply for a HELOC, make sure you answer a few key questions.

1. Do you know how a HELOC is different?

Equity is the key to both home-equity loans and HELOCs. Say your home is worth $250,000 and you owe $180,000 on your mortgage. You have $70,000 worth of equity.

Your lender might approve you for a home-equity loan of $50,000. You'd receive that money in a lump sum. You'd pay it back each month, with interest, just like you do with your primary mortgage.

A HELOC works differently. It acts more like a credit card, with your credit limit based on your home equity. If you have that same $70,000 of equity in your home, a lender might approve you for a HELOC of $60,000.

Instead of getting a lump-sum payment, you'd get that $60,000 in the form of a line of credit, and only pay back what you borrow. If you used $30,000 to remodel a kitchen, you'd only pay back that $30,000, with interest. If you used the full $60,000, you'd have to pay that amount back.

2. Do you mind a bit of uncertainty?

Another difference between home-equity loans and HELOCs is that the former come with fixed interest rates, while lines of credit usually have variable interest rates. This means that your initial interest rate will usually be lower than what you'd get with a home-equity loan.

But that initial rate will change over the life of your loan. It could — and usually will — climb depending on what economic indexes your rate is tied to. For instance, if your HELOC is tied to the Fed's prime rate, it will adjust every time the Federal Reserve adjusts this rate. Most HELOCs adjust either on a monthly basis or a quarterly one, rising or falling depending on the index to which it is tied.

Home-equity loans come with initial higher rates, but these rates are fixed, meaning that they won't rise — or fall — over time.

Are you OK with a bit of uncertainty when it comes to rates? If so, you could save significant money on interest with those low initial interest rates that come with a HELOC. You will have to take the risk that these low rates could one day rise higher than the fixed rate that you might pay on a home-equity loan.

3. How much flexibility do you need?

Home-equity loans are generally better for homeowners who need cash for a one-time event, such as paying for a child's college tuition. But HELOCs often work better when homeowners aren't quite sure how much money they'll need over time.

Say you're remodeling your kitchen, but you're not sure exactly how much that project will cost. You take out a $40,000 HELOC. If your remodel only costs $25,000, all you withdraw on that line of credit is $25,000, and that's all you have to pay back.

One of the main advantages of HELOCs is this flexibility: You only have to borrow what you need. And you don't have to know before applying for this line of credit exactly what that amount will be.

4. Can you pay it back?

Taking out a HELOC seems like an easy way to get quick access to a new line of credit. But before you take out a HELOC, make sure that you can pay back what you borrow.

Unlike a credit card, a HELOC is secured debt, which means that your creditor can take something from you if you fail to pay back what you borrow. In the case of a HELOC, the money you borrow is secured by your home. If you fail to pay back the money you borrow, your lender could begin foreclosure proceedings against you.

5. Are you spending your money wisely?

There are good and bad reasons to take out a HELOC. Paying off high-interest credit card debt is usually a smart decision because the rates on a HELOC are much lower. But homeowners do need to be careful: Again, not paying back a HELOC could result in a lost home. Creditors can't take your home if you don't pay your credit card debt on time.

Paying for major home improvements is also a good investment … usually. But tapping your equity might be a waste if you are making an improvement that won't add much value to your home. Generally, improvements such as updated kitchens and bathrooms, master-bedroom additions, and siding and roofing replacements will add value to your home. Adding a home office or in-ground swimming pool might not.

But maybe you don't plan on selling your home, and you simply want to add something that will boost your enjoyment of it. In that case, using a HELOC for home improvements that won't necessarily result in a big payoff can make sense.

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