What is a Home Equity Line of Credit? (HELOC)

What is a HELOC?

A HELOC allows homeowners to borrow against the equity in their homes, functioning as a revolving line of credit. Like a credit card, you can withdraw funds up to a predetermined limit, repay the borrowed amount, and borrow again during the draw period. This makes HELOCs an excellent choice for managing ongoing expenses or one-time financial needs.

How Does a HELOC Work?

A HELOC typically has two phases:

1. Draw Period: During this period, which often lasts 5 to 10 years, you can borrow funds as needed. Payments are often interest-only, making them affordable.

2. Repayment Period: After the draw period, you enter the repayment phase, lasting 10 to 20 years. During this time, you repay both the principal and interest, resulting in higher payments.

The Benefits of a HELOC

• Flexible Access to Funds: Borrow only what you need, when you need it.
• Potential Tax Benefits: Interest on HELOCs may be tax-deductible if used for home improvements. (consult a tax professional for more details) 
• Lower Interest Rates: HELOCs often have lower interest rates than personal loans or credit cards.
• Liquidity Management: A HELOC can act as a financial safety net, allowing you to manage cash flow without liquidating investments.

Real-Life Example: Sara’s Kitchen Renovation

Sara has been saving and investing to fund a $150,000 kitchen renovation. When she began, her income and tax rate were below 22%. Today, her income has increased significantly, placing her in the 32% federal tax bracket due to higher salary and bonuses. She now faces two financing options:

1. Liquidate Savings and Investments: If Sara liquidates her investments, she would trigger a 23.8% federal tax rate and a 5% state tax rate, costing her:

   • Tax Cost: $150,000 × (23.8% + 5%) = $43,200 in taxes.

2. Borrow Against a HELOC: Alternatively, Sara could borrow the $150,000 through a HELOC with a 6.5% annual interest rate. She plans to repay the loan in 30 months (2.5 years). Her total interest paid would be:

   • Interest Cost: $150,000 × (6.5% ÷ 12) × 30 = $24,375.

In this case, using a HELOC saves Sara $18,825 compared to liquidating her investments, while preserving her portfolio’s growth potential and avoiding additional taxes.

Managing Liquidity and Refinancing Debt

HELOCs can also be used to refinance high-interest debts, such as credit card balances. By consolidating these debts into a single, lower-interest HELOC payment, you can reduce monthly obligations and simplify your financial management.