Five HELOC Risks

With relatively low interest rates and tax-deductible interest, home equity lines of credit (HELOCs) have always been considered the best choice when it comes to home improvement loans. But while they might be the top lending tool for homeowners, HELOCs have their fair share of risks.

The phrase "one size fits all" might apply to ski caps and umbrellas; but it has no place in the world of financial instruments. A terrific opportunity for one individual might spell trouble for another.

A home equity line of credit (HELOC) is a perfect example. It has many tangible benefits, but the loan needs to be used in the appropriate situation; otherwise, the risks may outweigh the rewards. Here are five examples why one size doesn't fit all when it comes to home equity loans.

1. Low payments, little equity gained

A HELOC has a very attractive feature-the minimum monthly payment need only cover interest costs. A loan amount of $30,000, for example, might only require a minimum payment of $200. This allows you to float the balance from month to month. Over the long haul, however, if you make only the minimum payment, you'll never pay off any principal, and the loan will never go away.

2. Interest rates rise

Interest rates on HELOCs are usually based on the prime rate, which tends to hover in the single-digit range. A HELOC's loan rate is variable, however, and usually rises when the Federal Reserve increases rates to stem inflation. These increases can come quickly and may climb 2 percent or more. As a result, that low minimum payment will increase.

3. Hammered by hidden fees

Lenders lose money when borrowers refinance loans with another institution. To keep their loans in-house, lenders will tack on early-termination fees. These can be either a set fee, or a percentage of the loan balance. Before you take out the loan, look for a lender who doesn't impose these types of fees.

4. Losing home value

Another risk is that your home may decrease in value while you're borrowing more money. When it comes time to sell the house or refinance the loan, you may find that the equity that you had counted on has suddenly disappeared. Avoid this problem by making sure that the total amount of your home loans doesn't equal more than 80 percent of the house's market value.

5. Borrowing unwisely

A HELOC works well if you're borrowing for home improvements or to launch a business. Those types of investments can appreciate over time. If you're borrowing to finance a trip to Hawaii, the memory of a great vacation will eventually fade away with your suntan, but your debt will stay with you until the last cent is repaid.

HELOCs have plenty of upside; but every homeowner's situation is different. As with any financial tool, you need to consider all the potential risks, as well as the rewards. A HELOC is a great option-just make sure it's the right one for you.