Homeowners

Why It Might be a Smart Idea to Take out a HELOC Before You Need One

Most homeowners don’t think about getting a loan until there’s a current reason for it. Maybe the roof springs a leak, a major medical bill comes due, or you want to help put a child through college.  

But some homeowners take a more proactive approach and get access to funds they may, or may not, need. This can be helpful if a future job loss or major expense could damage your credit score and your ability to qualify for the loan with more favorable terms.

A Home Equity Line of Credit, or HELOC as it’s commonly called, allows homeowners to borrow up to a certain amount based on the equity they’ve built up in their home. Borrowers only use what they need during the draw period and then repay it over time.

For some, opening a HELOC while their income and credit profile are strong may be a smart way to create a financial back-up plan for future needs.

“It often makes sense to get approved for a HELOC before you actually need it, mostly because access to money seems to have a way of tightening up at the ‘worst’ possible time,” said Brett Johnson, owner of the Denver-area New Era Home Buyers.

While there are many benefits to a HELOC, there are also some downsides to understand.

What is a HELOC and how does it work?

A HELOC is a revolving line of credit, similar to a credit card, that’s secured by your home. It allows you to borrow against your home equity, which is how much you own outright on your property (not including what you owe on a mortgage.)

With a HELOC, you won’t receive a lump sum upfront. Instead, you’re approved for a credit limit and can draw up to it as needed during the draw period.

“One of the main advantages is that you’re only paying interest on what you borrow, and you can recycle that credit line,” said Johnson.

For example, if you’re approved for a $75,000 HELOC and you only take out $20,000, you’re only charged interest on the $20,000. Or, if you borrow $75,000 and then repay $20,000 during the draw period, you can borrow up to $75,000 again.

The draw period typically lasts five to 10 years, depending on your lender terms. Afterwards, you enter the repayment period where you’ll need to pay back the principal and interest. This period usually lasts for 10 to 20 years.

Leveraging a HELOC for flexibility

Funds from HELOCs can often be used for almost any purpose, offering you a lot of flexibility. If you know you may need to make home repairs or face a future expense, having a HELOC acts as a “just in case” resource.

It may also be beneficial to take one out when you have a high credit score, which may help you receive more favorable loan terms.

“Getting approved when your income and credit look clean may give you a backup plan you can lean on later, instead of scrambling under pressure,” Johnson said.

Having this type of flexibility can be useful because your costs may be uncertain or spread out over time. For example, if you know you want to make some renovations, a HELOC may make sense if you’re not sure right away how much you may need to borrow.

Instead of borrowing one lump sum, you can take out a smaller amount as needed and plan ahead for what those payments could look like.

Although alternatives like credit cards also provide flexibility, a HELOC stands out because of its cost.

In most cases, interest rates are lower than what you’d find for credit cards, making it a more affordable way to borrow money.

What homeowners should consider before opening a HELOC

Since a HELOC uses your home as collateral for your loan, there are some risks involved. In the worst-case scenario, if you’re unable to repay your loan, your home could fall into foreclosure.

That’s why it’s important to make sure that you make on-time payments, just like when you pay your mortgage. Be sure you’re only borrowing what you can afford to pay back.

Monthly payments may also fluctuate since many HELOCs have variable interest rates. During the repayment period, your payments may also change since you’ll be required to pay back the interest and principal.

Building a buffer into your financial planning in case monthly payments do rise could be a smart move.