Celebrate! You are now officially a homeowner. <insert dance and jig here if you like> For many, owning there first home is a dream come true. Becoming a homeowner comes with its own set of responsibilities, as well as benefits.
One of these alleged benefits is the ability for qualified homeowners to borrow against the equity in their home. This can be accomplished through a home-equity loan or a home-equity line of credit. While both options are popular among homeowners, here we look specifically at the home-equity line of credit as well as the benefits and drawbacks associated with it.
What is a home-equity line of credit?
The home-equity line of credit (HELOC) differs from the home-equity loan in that instead of one lump sum of cash being distributed to the homeowner, a line of credit is established from which they can borrow. Where a home-equity loan has a beginning and end with set payments in between, the HELOC offers more flexibility in the amount you borrow and in turn how much you monthly payments will be. You can borrow from a HELOC on an ongoing basis and your payments reflect the amount of money you have borrowed. It is important for anyone considering a HELOC to understand the pros and cons of this type of loan.
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Pros of a HELOC
- Instant access to high credit limits– If you have a lot of equity in your home, a HELOC will give you immediate access to a large amount of cash. This can facilitate home renovation projects, tuition payments or unexpected medical expenses.
- Lower interest rates– Compared to interest rates associated with credit cards and other types of personal loans, the HELOC usually offers a lower interest rate.
- Tax benefits– Considered a second mortgage, the HELOC offers tax benefits not associated with credit cards. Interest paid on a HELCO is tax-deductible.
- Repayment flexibility– Depending on your lender, you may have a great deal of flexibility in your repayment options. You may be able to opt for interest-only payments (not recommended) or turn the line of credit into a fixed-interest loan.
Cons of a HELOC
- It's Debt– No matter how you skin in, a HELOC is debt. Period. Don't kid yourself. Using HELOC's as your emergency is especially dangerous.
- Loss of equity– When you borrow against your home, you lose that same amount of equity. This can be a disadvantage to those who have paid off their mortgage or those who want to sell their home in a down market. If the value of your home drops, your lender also reserves the right to freeze access to your line of credit.
- Adjustable interest rates– When interest rates are tied to the prime rate, you risk paying much more than you originally thought if there is a dramatic increase in the prime rate. With an adjustable interest rate, there are no guarantees on how much you will pay from one month to the next.
- Risk of foreclosure– Whenever you use your home as collateral for a loan, you risk losing your property should you fail to repay the HELOC as agreed. No one wants to think of the worst case scenario, however you should carefully consider if you are willing to risk your home if the unforeseen happens and you are unable to meet your financial obligations.
My Experience With HELOC's
For the financially savvy person, HELOC's can make a lot of sense. Unfortunately, a lot of people that I've encountered with HELOC's also carry a good size of other consumer debt which has them over leveraged. For the person that has credit card debt and other consumer loans, I'm not a big fan.
Is the HELOC right for you?
Deciding whether a HELOC is right for you is a personal decision and one that should take into consideration your current financial situation, anticipated ability to repay, purpose of the loan and your risk tolerance. If managed properly and all conditions in the market and economy remain favorable, the HELOC can be beneficial to borrowers. Conversely if the homeowner isn't vigilant in managing the HELOC or changes in the market and economy create negative conditions, this second loan on your property could be the cause of additional financial stress.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.