Pros and Cons of a Home Equity Line of Credit
A home equity line of credit (HELOC) offers a convenient and flexible financing option for disciplined borrowers but can pose risks for those who aren’t.
If you’ve been paying down your house for a while, then a home equity line of credit (HELOC) offers a convenient way to tap your equity when you need it. Be aware, though, that you could face a substantial HELOC “payment shock” at the end of the loan period.
Let’s take a look at what a home equity line of credit is, plus the benefits and possible downsides of this type of borrowing.
What Is a HELOC?
A home equity line of credit allows you to borrow against the equity you have accumulated in your home. Unlike a home equity loan where a single lump sum is loaned to you, a line of credit allows you to choose when and how much of your equity you want to tap into.
A home equity line offers you a maximum amount you can borrow, based on the equity you hold, over a set “draw” period—usually five to 10 years. During this period, you need to only pay down the interest on what you’ve borrowed at the prevailing interest rate. At the end of the period, however, you need to start repaying the principal at current rates of interest.
Pros of HELOCs
Home equity lines offer a convenient way to access extra cash when you need it with few strings attached. You can use it to fund improvements to your home or to help pay for education, medical expenses, or even travel.
Borrow What You Need
Home equity lines allow you to borrow just what you need when you need it. Traditional home equity loans require you to borrow a large lump sum at one time, tapping more of your equity.
You need to repay only what you borrow, not a lump sum. You also need to make interest-only payments (if you choose) until the end of the loan period, when you are required to start repaying the principal.
Even with the recent interest rate increases, home equity lines of credit still compare favorably with the APRs on credit cards, making them useful for debt consolidation or long-term projects.
If you use a home equity line to pay for improvements or renovations to your home itself, then the interest you pay could be tax-deductible.
Cons of HELOCs
Home equity lines also come with some significant disadvantages compared to other forms of credit, especially a potential “payment shock” at the end of your draw period if interest rates rise.
You Need Substantial Equity
Home equity lines usually limit borrowing to 85% of your home's value, less your outstanding mortgage principal. You typically need to hold significant equity in your home to qualify for a line of credit.
Your Home Is on the Line
Having a substantial fixed asset like a house to borrow against is an advantage, but if for some reason you are unable to keep making payments on your loan, the bank could foreclose and you could lose your most valuable investment.
You Could Go Underwater
House prices look like they will continue to rise, but if the price of your home should fall you could quickly lose the equity you have borrowed against. This means you could owe more on your line of credit than your stake in your house is worth.
Variable Interest Rate Exposure
Unlike a home loan or a home equity loan, which both offer a fixed rate of interest, a line of credit is extended at a variable credit rate, with repayment periods lasting 20 years or more. So, if interest rates rise, you will be paying far more to repay what you have borrowed.
Risk of Overspending
Borrowing small amounts of money whenever you need it can catch up with you if you’re not careful. With repayment due only on the interest charged until the end of the draw period, you may be lulled into leaning more heavily on your line of credit than you had planned.
The HELOC Payment Shock
Unwary homeowners often receive a nasty shock when the draw period of their line of equity ends and repayment on principal comes due. Many people opened lines of credit at the height of the housing bubble, have borrowed heavily, and paid down only the interest that was due.
Many of these lines of credit are now entering the repayment phase, and owners are facing substantially higher payments on the principal they owe. Many people have been caught off guard by the sharp rise in interest rates.
When Is a HELOC Right for You?
Home equity lines remain a good option for as-needed funding if:
- You are a disciplined borrower with substantial equity in your homes
- You require more flexibility than other options, such as a home equity loan
HELOCs are particularly suitable if you plan to use your line of credit to make relatively small ongoing improvements and upgrades to your home. Talk to a responsible lender to see how a home line of equity might work for you.
How Can We Help You Unlock More Value?
At Members Heritage Credit Union we work with our members to help them make the most of their home equity.
Our home equity line of credit features a seven-year draw period and a 15-year repayment term with no prepayment penalty. We also offer:
- Competitive rates
- Loan-to-value ratio up to 100%
- Ease of access through your checking account
- No application or processing fees.
Click below to learn more about whether our home equity lines are right for you.
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