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For some, a Home Equity Line of Credit can be more of a liability than an asset.
If you’ve been paying off your mortgage for a couple of years and have built up some equity in your home, you have likely considered opening a Home Equity Line of Credit (HELOC).
What is home equity?
Home equity is essentially the amount of your home that you own. It is the difference between how much you owe on your loan and how much your house is worth.
For example, if your home is worth $200,000 and you have paid off $25,000 of your mortgage, plus put down 20% ($40,000), you would essentially have $65,000 equity in your home.
What is a Home Equity Line Of Credit?
A HELOC is a lot like a credit card, but the limit is based on the amount of equity that you have in your home. Many banks will give you a line of credit equal to about 80% of your loan-to-value ratio (LTV), so the owner of the $200,000 house in the above example would be able to borrow about $25,000.
» MORE: See today’s refinance rates
A HELOC is convenient for many reasons:
- You can open it but not ever use it and just keep it there as an “emergency fund.”
- The debt is sometimes tax-deductible, which is very convenient if you are looking to consolidate credit cards and other debt, which has a high-interest rate, and payments are not tax-deductible.
- You can use it to pay for large ticket items like a house renovation, medical bills, college tuition, or a new car where you need instant access to huge sums.
Like anything, a HELOC can get you in trouble. Here are 5 reasons that you might want to avoid getting a HELOC:
1.) Miss payments and you can lose your home: Unlike a credit card, a HELOC represents secured debt. Guess what the security on that debt is? Your home! Default on your HELOC and you could lose your home. If you are the kind of person who is predisposed to running up lots of debt, perhaps a HELOC is not for you.
2.) It’s not a dependable emergency fund: If you have set up your HELOC and plan to use it as an emergency fund, think again. Banks can freeze your HELOC at any time and often do when there is a drop in the job market or a drop in your credit-both of which can happen at a time when you most need your emergency fund. Again, if you are in a situation where you end up not being able to pay the HELOC back, you will lose your home.
3.) It’s not free money, just more debt: A HELOC can make you think that you actually have more money than you really do. It’s not free money, it’s just more debt. You’ve worked hard to build up the equity in your home; it’s not worth it to blow that with carefree HELOC spending. Plus, when you have to pay the HELOC back, you will have the double whammy of paying your mortgage and the HELOC at the same time. Isn’t your goal to ultimately get out of debt?
4.) Some HELOCs require a balloon repayment: Some HELOCs require that you pay back all of your cash using a balloon payment at the end of your withdrawal period. If finances are already tight and you are literally using your HELOC as a credit card, a lump sum payment may be out of the question.
5.) You may not be able to refinance without paying off your HELOC first: Some lenders won’t let you refinance without paying off your HELOC first. If you have plans to refinance in the next few years and think that the HELOC will be too much of a temptation, don’t get started.
The most important thing to remember is that a Home Equity Line of Credit is not free money. It’s debt that you are adding to your pile, debt that you had previously paid off.
Of course, there are many good uses for a HELOC and many benefits of using that type of credit over high-interest rate credit cards. Still, unless you have a solid repayment plan and have carefully considered all of the things that could possibly go wrong with your HELOC, you shouldn’t get one!
Home Equity Line of Credit Mistakes to Avoid
When utilizing a HELOC, it’s crucial to understand the potential pitfalls so that you can responsibly manage your finances. Here are some mistakes to avoid:
- Excessive borrowing: One of the most common mistakes is borrowing more than you can comfortably repay. It’s essential to assess your borrowing capacity before taking on a HELOC. Avoid the temptation to access the full credit line if you don’t genuinely need it, as it can lead to excessive debt and financial stress.
- Misusing the funds: Another mistake is using a HELOC for unnecessary or frivolous expenses. It’s crucial to have a clear purpose for the borrowed funds, such as home improvements or debt consolidation, and stick to that plan.
- Overlooking fees and terms: Thoroughly review the terms and conditions of your HELOC agreement. Having a clear understanding of factors like the interest rate, repayment period, draw period, and any associated fees or penalties will help you assess the true cost of a HELOC.
- Not reviewing and reassessing regularly: Regularly review your financial situation and the terms of your HELOC. Periodically assess whether the HELOC still aligns with your goals and financial needs. If necessary, consider refinancing or exploring alternative options to ensure you’re utilizing the most appropriate financial tool.
Alternatives to a Home Equity Line of Credit
If a HELOC doesn’t fit your financial needs, there are several other options worth considering:
- Home Equity Loan: A home equity loan, otherwise known as a second mortgage, allows you to borrow a lump sum of money using your home as collateral. Unlike a HELOC, which provides a revolving line of credit, a home equity loan offers a set loan amount and consistent monthly payments. This option offers a stable and predictable repayment plan with a fixed interest rate.
- Cash-Out Refinance: A cash-out refinance involves refinancing your existing mortgage for a higher loan amount and receiving the difference in cash. This option allows you to tap into your home equity while obtaining a new mortgage with potentially more favorable interest rates and repayment terms.
- Personal Loan: If you need a smaller loan amount or don’t want to use your home as collateral, a personal loan can be a viable alternative. Although personal loans can offer consistent monthly payments, they often come with higher interest rates because the loan is unsecured.
- Credit Cards: Credit cards are a viable option for smaller expenses or short-term financing. They offer convenience and flexibility, but it’s important to manage them responsibly to avoid high-interest debt. If you can pay off the balance within the interest-free grace period or take advantage of promotional offers, using a credit card can be a cost-effective option.