A Rule of Thumb for Tapping Home Equity

You plan to keep your house for a long time. But it needs some work. Renovations are expensive, and you want to avoid getting in over your head when you borrow against equity. With that in mind, take an old-timer's advice on using a variable-rate home equity line of credit: "Don't borrow a lot, and don't borrow for long."

That guidance comes from Lou Barnes, who retired in 2023 after working for 40 years in real estate and mortgage banking. Barnes saw his share of dramatic swings in interest rates. That experience informs his advice for using a home equity line of credit, or HELOC:

Borrow an amount that you can pay off reasonably quickly, then follow through with your rapid repayment plan.

Barnes's advice has an implication: If you need to get your hands on a chunk of change that will take many years to pay off, consider a fixed-rate home equity loan.

Equity lending described

Let's step back to explain home equity products, in case you haven't pondered them lately.

Your equity equals your home's current value minus the amount you owe on it. You can borrow against this equity, preferably to pay for home repairs, renovations and additions. You have three ways to tap equity: a HELOC, a home equity loan, or a cash-out refinance.

A HELOC is a second mortgage that behaves like a credit card, where you have a credit limit, and you can borrow as you need to, up to that limit. Then you can pay some or all of the HELOC balance back, giving you room to borrow again.

A HELOC has a variable rate that goes up or down whenever the Federal Reserve raises or cuts short-term interest rates. The credit line has a draw period, often 10 years, when you can pay only interest each month. (Though you'll avoid a nasty payment shock later if you repay principal before you're required to.) Meanwhile, you keep paying your primary mortgage as usual.

With another type of second mortgage, a home equity loan, you borrow a specific sum at a fixed interest rate. You make equal monthly payments for a set number of years. This makes home equity loans simple to budget for. Fewer lenders reviewed by NerdWallet offer home equity loans than HELOCs.

With a cash-out refi, you refinance your mortgage for more than you owe, and deposit the difference into your bank account. The new home loan comes with a new mortgage rate. Lots of people got cash-out refinances in 2020 and 2021, when mortgage rates sank below 4%. Now that mortgage rates stand around 7%, no one with an ultra-low rate wants to replace it with a higher rate. That leaves the other two ways of extracting equity as reasonable options.

"There's always going to be this need for people to tap into their equity without shutting down their record-low-for-first-lien mortgages," says Tom Hutchens, president of Angel Oak Mortgage Solutions.

Remember that rates could rise one day

When borrowing equity nowadays, HELOCs get most of the action. But borrowers should exercise caution because a HELOC's variable interest rate can rise fast.

Look what the Federal Reserve did after inflation surged in 2021 and 2022: The central bank raised interest rates by 5.25 percentage points in 16 months. Rates on HELOCs went up by the same amount.

The Fed's aggressive rate hikes brutalized any poor soul lugging a big balance. Take the hypothetical borrower who had a 4.25% interest rate on a $100,000 HELOC balance in March 2022. By July 2023, that interest rate would have jumped to 9.5%. The monthly interest payments would have increased from $354 to $792.

You can insulate yourself from a payment shock by limiting your variable-rate HELOC borrowing. If rates climb and you have a HELOC balance of $10,000 or $20,000 or even $50,000, you might pay some of the principal each month, Barnes says. But if you borrow more than that, "the struggle begins to retire it or knock down the balance or deal with it in some way."

'Don't borrow a lot' definition

Home equity loans make more sense at high loan amounts, says Marguerita Cheng, a certified financial planner and CEO of Blue Ocean Global Wealth, in Gaithersburg, Maryland.

Your threshold of what constitutes a high loan amount depends on your circumstances. Cheng ballparks it as somewhere between $25,000 and $50,000. "If they're just trying to get new appliances, countertops and paints and redo the kitchen, I think that they can pull that off with a home equity line of credit," she says, "But if it's something like an addition, maybe a loan might be better."

There's your imprecise definition of what "don't borrow a lot" on a HELOC means: somewhere between $25,000 and $50,000, or between a modest renovation and an expensive addition. You judge where to draw your personal line.

'Don't borrow for long' definition

"Don't borrow for long" has a more solid definition. "If it's not a lot of money — they probably can pay it off in two or three years, you know — the line of credit makes sense," Cheng says.

Remember that HELOC rates respond to an unpredictable market. If you carry a HELOC balance for more than two or three years, you risk getting caught in a Fed rate hike frenzy. A fixed-rate home equity loan might work better.

This brings up a tip: Some lenders let you borrow from your HELOC and then convert some or all of your balance into a fixed-rate, closed-ended loan. In other words, a home equity loan. Look for this feature when shopping for lenders.

HELOCs and credit scores

None of this should scare you off from borrowing your home's equity, especially if you use the money to fix up your home. In fact, observers question why people haven't tapped more of their equity.

Outstanding HELOC balances totaled $387 billion in the third quarter of 2024, a 10.9% increase compared to a year before, according to the Federal Reserve of New York. The increase in HELOC borrowing began just a while ago; as recently as the second quarter of 2022, year-over-year HELOC balances had gone down.

"Given record levels of home equity and the undesirability of cash-out refinancing, one may actually wonder why we are not seeing a larger surge in HELOC originations," read an August 2024 post in the New York Fed's Liberty Street Economics blog.

The number one reason involves credit scores.

"Back in the global housing bubble, if you had a credit score above 620, you could get a HELOC," says Mark Fleming, chief economist for First American Financial, a service provider for the real estate industry. "Now you've got to be in the mid 700s or above."