The beautiful and fragrant rose has a dark side-if you're unprepared when you touch the stem, you're bound to be wounded by a prickly thorn. Like the rose, a home equity line of credit (HELOC) can be a beautiful financial instrument, especially if you need funds for home improvements or unanticipated medical expenses. But if you're not careful, your finances may get pricked by a painful thorn, and you may bleed for years to come.
Home equity line of credit
A HELOC is a revolving line of credit that's backed by the equity in your home. Banks will generally let you borrow up to a maximum of 80 percent of that amount, money you can withdraw as needed. Interest will be charged on the amount you draw, and you frequently have the option to pay only interest during a specified period. Once that time ends, the entire amount that you borrowed will be due.
HELOCs have many potential prickles, but the first and most dangerous one is that the interest rate will vary. What does this mean? Every month, the amount of interest that you pay changes, so you can't reliably predict the amount that will come out of your monthly budget.
When the economy is struggling, interest rates may be low in order to stimulate growth and spending, and you may be tempted to withdraw money because it seems like an inexpensive way to access cash. However, as interest rates rise-and they always do-the monthly amount due will continue to increase, and it may rise out of your financial comfort zone.
This scenario contributed to the mortgage crisis. Many homeowners with adjustable-rate loans were seduced by low introductory rates, but when they expired and regular rates kicked in, these homeowners were unable to meet their monthly obligations. Many lost their homes, which is a potential consequence of HELOCs, as well.
Paying the piper
The other huge danger of HELOCs is that many people withdraw money with no definite plan as to how to pay it back. Many home equity loans offer the option of paying interest only during the life of the loan, which means that when the loan expires, the total principal amount borrowed is due. If you choose to pay only interest, where will the money come from when this happens? If you've tapped too far into your home equity, you may not be able to get a new loan to take you out of this precarious situation.
Some loans allow you to convert your principal balance into a fixed-rate loan once the interest-only period ends. Make sure you know which kind of loan you have before signing the papers, so there are no surprises down the road.
Like a rose, a HELOC can be beautiful, especially if you need funds in a hurry. Make sure you understand what you're getting into, though, so you don't get hurt in the end.