Pros and Cons Of A Home Equity Line Of Credit

You have just purchased a home that you love or you have been in your home for a while. There are some things you would change, though, like that outdated master bathroom. Of course you would love to remodel it, but that costs a pretty penny and it's just not in the budget.  This is where some people take out a line of credit on the equity in their home (assuming you have some built in value to your home). This may seem like a great idea, but you really need to have a complete understanding of how these loans work as well as what the positives and negatives are.

Below are the key details to know about before opening a home equity line of credit (HELOC).

How does a home equity line of credit work

With this type of loan, your home is used as collateral against the money you are borrowing from the bank.  One of the key differences between this and other home loans is that you are not borrowing a set amount to pay back over a specified period of time.  Rather, you borrow against a line of credit and make a partial or full payment towards the balance each month.

With that being said, money can only be withdrawn for a set period of time. You are usually given 5-10 years to take money out and any payments you make go solely towards the interest.

When you should take out a home equity line of credit

Using a home equity line of credit to do renovations and repairs to your home can be a smart move since this will usually add to the value of your home.  Nonetheless, many homeowners take out one of these loans to cover other things.  This includes paying for college, buying a car, consolidating debt etc.  One reason not to take out one of these loans is to cover everyday necessities.  If you cannot pay your bills with your current income, you should take time to come up with a maintainable budget.

How much will you be able to borrow

Equity depends on the following: the value of your home and the amount still owed.  This will be what your loan is based on. 75%-85% of the difference between the two is usually where your credit limit will fall.

So as an example,  if your house is worth $500k and you still have $350k, your bank would offer maybe 75% of the home's value.  That would be around $375k . You would then subtract the $350k you owe making your max credit limit $25k.  Before a bank will consider giving you a loan of this size, they will look at not only your income, but your credit score and any other debts you have.

There are some things to keep in mind with home equity lines of credit.  Some loans may require that you borrow a minimum amount every time or require that you take an advance at the inception of the loan.  A few may even require that you always carry a balance.  For this reason, it is important to know the details of any loan you take out.

What type of interest rates you can expect

Typically, home equity lines of credit carry an adjustable rate.  This means the rate will fluctuate with whatever index it is tied to, like the prime rate. Luckily, the interest rate does have a cap for how high it can go.  For example, if your loan has a 15% cap, you will not see it rise above that. Some plans may even offer an interest rate cap during a given time period.

Additional fees

Just like your mortgage, you will typically have to pay additional fees when you take out a HELOC.  Here are some of the fees you may incur:

  • A fee for the application
  • Appraisal for the property
  • Charges you pay upfront like “points”
  • Closing costs

In addition, there are some loans that carry continuous fees that are applicable until the loan expires. This could be a loan management fee or transaction fee each time your borrow money.  All in all,  you can expect to pay hundreds in extra fees should you decide to open a home equity line of credit.

Advantages of a home equity line of credit

There are definitely some advantages to this type of loan vs others. Here are a few:

  1. Flexibility. You choose how much to borrow during the draw period.  Once it ends, you typically have a lengthy period of time to repay the loan.
  2. Lower interest rates.  Because your home is used as collateral, this type of loan is less risky for the lender. Hence, the interest rate tends to be lower.
  3. You can pay early. Regardless of the required minimum payment, you can always make additional payments.
  4. Tax Deductible. Just like a traditional home loan, the interest is typically tax-deductible.
  5. You can back out. As long as you cancel within three days, you are not obligated to pay anything.

Negatives of a HELOC

Although a HELOC can be a great way to borrow money, it’s not for everyone. HELOCs have some serious negatives, including:

  1. Foreclosure risk. Because you are using your house as collateral, a HELOC is risky.  If you feel your income is not stable enough, this may not be  a good idea for you.
  2. The value of your home can drop. If the value of your home goes down, you may end up owing more than the value of your home.  If your home is sold, the full value of your home equity line of credit will be due immediately.
  3. Your credit can be frozen. Should the bank see your home value drop or that your income has taken a big hit,  they can put a hold on your credit line.
  4. Changing rates.  Having an adjustable rate loan means the payment can go up high and fast. If you are on a strict budget, this can be a serious issue. Prior to taking out a loan, be sure to find out what the cap is for the interest rate and make sure you can make the payment if the rates were to go that high.
  5. Advance costs. As mentioned above,  the fees you have to pay upfront can be in the hundreds. If you are only in need of a small loan, this may not make sense for you. In this instance, you are better off applying for a credit card. With that being said, banks are sometimes willing to work with you on the closing costs so be sure to inquire.
  6. Large final payment. Upon expiration of the loan, if you are carrying a balance, it is due in full.  If you are not prepared to pay this, you could be at risk of losing your home.
  7. Renting can be prohibited. If you think you may be moving anytime in the near future, this loan is not right for you.  You will not be able to rent out your home and the entire balance of the loan will be due if you sell the home.

Getting the Best Deal

If you make the decision that a HELOC is the right choice for you, be sure to comparison shop for the best deal. Contact your bank first as they may offer discounts for regular customers.  Make sure to ask for a detailed quote that includes all information regarding fees, caps and interest rates.  You can now use that as a base to compare other offers to.

Keep these details in mind as you shop around for a loan:

  1. Check the Interest Rate. Since the rates are usually variable, you cannot just compare a single number.  You need to inquire as to what index they use to determine the rate ( for example, the Prime Rate or a U.S. Treasury Bill rate) and what the margin would be. You then want to do some research on that index and see how much it tends to fluctuate over time and what has the interest rate been at its highest.
  2. Compare Caps. It’s also important to know what the cap on your interest rate is. That will tell you how high the monthly payment on your loan can possibly go if interest rates rise. Check both the lifetime cap on the loan and the periodic cap, if there is one. Make sure that you know, and can afford, the maximum possible payment.
  3. Find out all fees. Besides comparing interest rates, you will also want to look at any closing costs or other fees.
  4. Be wary of introductory offers. Introductory rates are tempting but they only last a short period of time, usually six months.  Be sure to find out when it expires and what type of payment you are looking at when it does.
  5. Know the breakdown of your payments. Inquire about how your payment is divided between the principal vs interest.  If they go towards the interest only, you will wind up having to pay the entire balance when the plan ends. If the payment goes towards both, find out if the portion that goes towards the principal will be enough to cover the remaining balance when the loan ends. In some instances, you may be able to add on an extension to your loan or refinance that large payment you may be hit with.
  6. Inquire about penalties.  Making a late payment may happen at some point. Find out the penalties for doing so.  Also ask about what would have to take place for the loan to go into default.  If this occurs, they can ask for the entire balance to be paid in full immediately.  If you are unable to do so, they seize your home.
  7. Know the law. By law, a lender  must communicate all details and fees surrounding your loan. They may not charge you a single fee until you have received this information. If for any reason they try to change the terms prior to you signing, you have the right of refusal and they must refund any fees paid. If you have already signed, you still have three days to change your mind.

Final word

Taking out a home equity line of credit can be a smart financial move for many.  It is a relatively cheap way to borrow money for improvements that can add value to your home. The main downside is that you are putting your home at risk should you not be able to make the payments.  For this reason, it's important you review all your options and do the math.  If you have any concern about being able to make the payments, this type of loan may not be for you.

 

 

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