HELOCs offer low initial rates and financial flexibility, but are more unpredictable than a standard home equity loan. So are they the right choice for you?
As with most loans, HELOC's have experiencing record-low rates in recent years. If the Fed eventually raises short-term rates (and they will), many homeowners with HELOC's will be in for an unwelcome surprise.
Does that mean that you should jump on a HELOC now while the rates are low? Due to the way that HELOC loans are structured, probably not-but read on to understand exactly why.
What is a HELOC?
HELOC stands for Home Equity Line of Credit. It is a secondary mortgage loan based on the equity that is in a person's home. These loans offer high limits with low-interest rates because you are putting up your home as collateral.
This type of loan is different from your primary mortgage in that you don't get a lump sum payment. Instead, the loan acts as a credit card or checkbook and you can take out sums at any time during a 5-10 year withdraw period. During that withdraw period, the user is only required to pay interest. In the end, you only owe on what you take out. During the following repayment period, which is generally 10-20 years, the borrower is required to repay the principle as well as interest payments.
The amount of credit available is determined by subtracting the balance that the owner owes on his or her first mortgage by a percentage of the appraised value of the home, which is usually 80%.
Say you purchased your home for $400,000 and you currently owe $300,000 on the loan. If your home is appraised at $600,000, you will be able to get a line of credit worth about $240,000 (or 80% of $300,000).
Another big difference between a HELOC and most other loans is that the interest rate is almost always variable. For that reason, it doesn't quite make sense to jump on a HELOC now while the rates are low as there's no way to lock in the rate.
What you can use a HELOC for?
There are lots of ways to utilize a HELOC, but here are some things that people commonly use them for.
- Home renovations: You can use it to actually raise the value of your home by sinking the money into home improvements.
- For emergency savings: Take out all of the money available to you and put it in a bank that gives you a higher interest rate than you are paying on it already and you will have it in store to use for an emergency.
- For education: When parents come up short on college, they can use the money to pay for tuition.
- For medical bills: In emergency situations, a HELOC can be cheaper than racking up credit card debt.
What are the benefits?
The interest that you pay is typically deductible under federal and many state income tax laws. This can greatly reduce the cost of borrowing funds compared to other methods of borrowing.
HELOC's are flexible both in what you can take out and how you pay them back. Maybe you took out a HELOC loan for $80,000, but only ended up needing $20,000? Then that's all you take out. Also, depending on the loan, there are lots of different ways that they can be paid back.
What are the downsides?
- The interest rate is variable, which can get you into trouble-especially when borrowing such large amounts of cash.
- The line of credit can be frozen by the bank at any time, especially if your property value drops-which can delay planned payments.
- You are putting your home up as collateral and risk losing it if you default.
HELOC loans are a good resource for anyone who needs a large cash infusion. However, the cash isn't free and anyone considering a HELOC should work with their financial advisor to make sure that they are helping themselves in the short term and the long term.