The Risks of HELOCs
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UPDATED: Feb 9, 2021
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HELOC is an acronym for “home equity line of credit.” When obtaining this form of financing, borrowers use their home as collateral for what’s called a line of credit. This line of credit is a well of money that can be tapped into whenever the borrower chooses and its value is based on the existing equity in a home. Equity is simply the value of a home minus the amount of outstanding debt against that home.
Borrowers are able to withdraw money from this line of credit, but whenever they do so, they are charged interest.
Like other types of home loans, equity lines carry an element of risk. They act almost like a double-edged sword: they can be invaluable tools in the right situation, but the potential to hurt oneself while using them is very real as well.
The Danger of Changing Rates
Home equity lines of credit typically have adjustable rates, just like some home loans. However, unlike adjustable home loans, which are often tied to Treasury Notes, equity line interest levels are tied to the prime rate index. Adjustments to the prime rate index correlate to changes in a HELOC’s interest levels.
As might be expected, these adjustments can work either for or against borrowers. In the event that the prime rate index causes interest levels to rise, borrowers will feel the immediate effects come their next monthly payment. Similarly, if the prime rate index drops, so too will a borrower’s monthly payment.
But like adjustable rate home loans, HELOC interest hikes tend to receive the most attention, as an interest increase may put a strain on a borrower’s budget. Without savings or sizable income, borrowers risk missing payments, which could lead to penalty fees, default, or, in the worst case, foreclosure.
A Balloon to Pop
Some lenders offer interest-only payment options. An interest-only payment is a method of repayment in which a borrower is only responsible for repaying the HELOC’s accrued interest for the duration of their credit line. However, when the HELOC’s term expires, the full principal amount is due in one lump sum—which is called a balloon payment.
Frugal borrowers may be tempted by interest-only payment options since they’re usually advertised to come with lower monthly payments. While on the surface these may sound like amazing deals, borrowers must remember that even if they only pay interest, they still have the large looming principal payment remaining.
Having to make one massive payment to cover an entire credit line can be a difficult prospect for many home loan borrowers. Borrowers should only pursue interest-only options if they are able to secure enough money to pay them come their term’s expiration. If home loan borrowers are unable to meet that final balloon payment, they risk defaulting on their credit line.
Money Isn’t Free
Despite all of their risks, HELOCs can prove to be invaluable tools when wielded by informed and financially responsible borrowers.
For example, a HELOC costs little to nothing to establish and accrued interest is tax deductible. Even accessing funds is as simple as using a check or credit card.
However, lines of credit can be prone to overuse and misuse. A line of credit, whether it is a credit card or HELOC, may be viewed as “free money” by inexperienced and uninformed borrowers. Consequently, borrowers can easily begin living beyond their means by spending money frivolously. HELOCs, when misused and mismanaged, may end up landing borrowers into heavy debt.
Experienced borrowers, on the other hand, treat their line of credit with care and responsibility, knowing that every dollar spent must be repaid. Wise borrowers will also keep in mind that their home is the collateral in this form of home loan financing.
Home loans, such as HELOCs, have risks that are not to be taken lightly. Borrowers are vulnerable to interest rate changes that can drastically impact their monthly expenses and budgeting. Uninformed borrowers opting for balloon-loan type payment plans can find themselves at risk of owing large sums of money. Individuals using a home’s equity as their free checking account will quickly realize the dangers of runaway debt. HELOCs should be reserved only for informed borrowers who understand the risks involved.