HELOCs and refinancing: borrowing against your home

If you have built equity in your home, you can borrow against it. The two common ways are a home equity line of credit and a refinance, and each has its own costs and risks. Equity is the difference between your home's value and what you owe on it.

The short version: a HELOC is a flexible credit line at a variable rate. A refinance replaces your mortgage with a new, larger one. Both put your home on the line, so borrow for things that hold or add value.

How a HELOC works

A home equity line of credit (HELOC) is a revolving credit line secured by your home. You can borrow, repay and borrow again up to your limit, and you pay interest only on what you use. Federally regulated lenders typically cap a HELOC at 65% of your home's value, and your mortgage and HELOC together at 80%.

The rate is variable and is usually higher than a mortgage rate, since it is tied to prime plus a margin. The minimum payment is often interest only, which means your balance does not fall unless you pay more.

How a refinance works

A refinance replaces your mortgage with a new one and gives you the difference in cash. A typical refinance can allow you to borrow up to 80% of the home's value, subject to qualification and the lender's rules. You get a mortgage rate on the new amount, which is usually lower than a HELOC rate. The costs are a possible penalty for breaking your old mortgage, plus legal and appraisal fees. A refinance also resets your term and may reset your amortization.

Some lenders offer readvanceable mortgages, which combine a mortgage and a HELOC, so your available credit grows as you pay down the mortgage.

Example: $800,000 home with a $400,000 mortgage

• 80% limit: $640,000 in total debt.
• Room to borrow: $240,000.
• A HELOC alone would typically be limited to $520,000 (65%), which is not the binding limit here.
• Interest on $50,000 drawn at 6% is about $3,000 a year, or $250 a month, if you pay interest only.

Costs and risks

• Your home is the security. If you cannot pay, you could lose it.
• Variable rate risk. HELOC payments rise when prime rises.
• Qualification. Both options require approval and count against your debt ratios, so they can limit other borrowing.
• Penalty and fees. A refinance may carry a penalty and legal and appraisal fees.
• Equity erosion. Borrowing for spending, not value, shrinks your equity.

Tax treatment

Interest is generally tax-deductible only when the borrowed money is used to earn income, such as an investment. Interest on borrowing for a renovation or personal spending is not. Ask an accountant about your situation.

When it makes sense

Use equity for things that hold or add value, such as renovations, or to consolidate high-interest debt with a clear repayment plan. It is a poor choice for everyday spending or for investments you cannot afford to lose.

Compare the full cost of each route with a mortgage professional, including the penalty and fees on a refinance and the rate on a HELOC.