HELOC Vs. Credit Card: Which Is Better for Emergency Cash?
As its name implies, a HELOC or Home Equity Line of Credit essentially differs from the other forms of home loans, in that instead of receiving a lump sum upon loan approval, the borrower gets a revolving credit line which he can draw on should the need arise.
In that respect, it works in the same way as a credit card does, and you only pay for the portion of that credit line you use.
That is where the similarity ends though, as HELOCs and credit cards also differ in many other ways.
So, which line of credit should you keep on standby for that occasional home project and other out-of-the-budget expenses?
This HELOC vs. credit card comparison discusses the factors to consider before taking out either of them.
Let's start with the basic features:
Compare Features of HELOC vs. Credit Cards
|Payment Period||5-20 years||Less than 5 years|
|Payment Terms||Flexible||Minimum Amount Required|
|Fees||Application/Closing Fees, Annual Fees||Annual Fees plus Other Types of Charges|
The ABCs of a HELOC
A HELOC is set up as a line of credit for some maximum draw, rather than for a fixed dollar amount.
For instance, if you take out a standard mortgage, refinance or home equity loan for $100,000, you receive the full amount at closing.
With a HELOC, you receive the lender’s promise to advance you up to $100,000 in an amount and at a time of your choosing.
You can draw against the promised amount using a special credit card, debit card, check or other means your HELOC lender might have set up for you.
But even better than using a super-charged credit card, you get to write off the interest on your taxes (on balances up to $100,000) with a HELOC.
You can’t do that with credit cards. Upfront costs for HELOCs also are relatively low.
A popular product with homeowners before the 2008 real estate crash, precipitated by among other things like people using their homes as their personal piggy banks, the HELOC seems to be back in vogue.
Although HELOCS have some clear advantages, don’t assume you’ll automatically qualify for one.
You’ll need to meet your lender’s standard for income and credit quality, and, of course, you’ll need that all-important home equity -- that positive difference between what your home is now worth and what you owe on your current mortgage.
“Never forget that the ‘E’ in HELOC stands for equity,” said lender Kent Sorgenfrey, with Irvine, Calif. mortgage lender, New American Funding.
Provided you meet the criteria, you now need to know some of the HELOC’s disadvantages. Even if you roll on three good tires, one bad or bald tire could throw you into the ditch financially.
Secured Vs. Unsecured Debt
There are both advantages and disadvantages on taking out a secured type of credit.
With a HELOC, if you have sufficient equity on your home, you can apply for a sizable amount, and it will likely be granted for as long as you can establish that you have the means to pay it back.
On the other hand, most credit card issuers are slashing credit lines of consumers in anticipation of the rising card defaults.
Even those who have excellent credit scores and a clean payment history have been subjected to such measures.
So while you don’t need any collateral to avail of a credit card, it's unlikely that you will be given or be allowed to maintain a high credit limit.
But when evaluating the HELOC vs credit card in terms of the need for collateral, it's worth taking the time to study what the consequences will be if you fail to meet your loan obligations.
A credit card default can put a serious dent on your credit score and can lead to debt settlement or bankruptcy filing.
These options however, are much better than having your home taken from you – which is the worst case scenario with a HELOC.
The Lower Interest Rate Option
The interest rates for both the HELOC and credit card are variable.
The former adjusts with changes in the prime rate which typically changes monthly, while the latter is dependent on a lot of factors, some of which are beyond the cardholder's control – the credit score, payment history, or even just the bank's or issuer's decision to raise interest rates.
HELOC interest rates are within the 5% - 6% range while the average rate for credit cards is around 12%.
If your purpose is to pay-off a high-interest debt, there are still a handful of credit cards that offer very low Balance Transfer Rates – even lower than HELOC – but you would need to have excellent credit history for this, and if you use the card for regular purchases, that's where you could get slapped with sky-high rates.
Payment Period and Terms
As with any home loan, the payment period for a HELOC can stretch to as long as 10 to 20 years, with the added option to pay the interest only on some months.
With a credit card, the validity period would usually be between 2 to 4 years only, although you do have the option to renew it for as long the bank allows you to.
The minimum amount required every due date comprises of both the interest charged for that particular period and a portion of the principal amount.
A HELOC could cost more upfront because there are lenders that charge application, appraisal, and processing fees.
After the initial costs, however, the fees are pretty straightforward, such as an annual fee, and depending on the lender, a non-usage fee, which is applied if the HELOC remains unused for a time.
In contrast, credit card companies rarely let you pay significant costs upon applying or approval of a card, and in most cases, annual fees, amounting to about $50 to $100, are waived on the first year.
Aside from annual fees though, there's also a whole lot of other fees to contend with where applicable, such as balance transfer or cash advance fees, finance charges, late payment, and over limit fees.
In summing up all the factors involved in both alternatives, these stand out clearly:
HELOCs allow larger loan amounts, charge lower interest rates, and have longer payment terms.
The choice between getting a HELOC or a credit card however, would boil down to whether or not you are willing to take the risk of having a foreclosure on your hands in the future.
You know that if you live long enough, that emergency is going to come.
Maybe you’ll need emergency dental implants after a wild throw knocked out your two front teeth at your company’s annual softball game.
Perhaps, you have to cover your daughter’s first tuition payment at MIT. (Why didn’t she agree to go city college for the first two years?)
But like any emergency measure, you have to know when to use it and apply it.
I mean, as much as that spare tire might have saved you, you don’t keep driving around on spare tires.
You use it for a defined period of time or with an exact plan in mind, then you move on.
So, what would be a good scenario for using a HELOC (pronounced HEE-LOCK)? Well, let’s take one step back first and describe exactly what it is.
A HELOC's Disadvantages
The biggest caution sign has to do with the HELOC’s interest rate. It’s variable, meaning the rate can go up and down daily like a rollercoaster.
So, a HELOC is essentially an adjustable rate mortgage (ARM), but most ARMs at least have caps limiting the size of any rate change. Most HELOCs have no adjustment caps.
As for a little rate history, HELOCs are tied to the prime rate. In the three years prior to June 29, 2006, the prime rate changed 17 times.
In 1980, it changed 38 times, ranging between (close your eyes) 11.25 percent and 20 percent!
“The good news about a HELOC today,” Sorgenfrey said, “is that rates are extremely low.”
Whatever is borrowed, of course, must be paid back. Typically, a HELOC may have a minimum monthly payment requirement (often interest only).
This doesn’t preclude the borrower from making a repayment of any amount so long as it is greater than the minimum payment but less than the total outstanding.
“As the borrower pays down any principle on an interest-only loan, it automatically reduces the required interest-only payment, so it gives the borrower control,” Sorgenfrey explained.
Usually, the borrower pays interest only on the balance for the first 10 years -- this is usually the draw period -- before being faced with paying off the full loan (principal and interest) at whatever the current interest rate is at the time.
The full principal amount could be due at the end of the 10-year draw period, either as a lump sum balloon payment or according to an amortization schedule extending another five, 10 or more years.
HELOC Rolls Back the Odometer
Now let’s discuss our hypothetical HELOC candidate, a 65-year-old modest income earner who will have to rely on $1,000 a month in Social Security after she retires to help pay her monthly mortgage of $400 on her $200,000 home on which she still owes $40,000. With minimal retirement savings, she’s in a tight box.
She has options, however.
- She could live like a hermit and starve herself, and when she finally pays off the mortgage, her heirs will bless her for their inheritance.
- She could seek a reverse mortgage, but unlike HELOCs, loan expenses are very high.
- She could apply for a HELOC (while she’s still gainfully employed) and use the proceeds to pay off her mortgage. In turn, her interest-only payments for the next 10 years will be about $100 a month, not the $400 a month. At the end of the 10 years, she can sell the house, repay the relatively small balance or choose a reverse mortgage.
The point is, her HELOC has bought her precious time during a personal financial crisis. Her stop sign is only temporary. She can move ahead at a new pace.
Of course, there’s a cost (lower gas mileage) to carry that spare tire. But it’s good to know it’s there when you need it.