A home equity line of credit (HELOC) isn’t the most suitable option for every borrower. HELOC loans give borrowers an easy and convenient way to tap into their home’s equity. However, there are also some risks involved with taking out a HELOC. This article will help you determine if a home equity line of credit is right for you.
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The Risks of Removing Equity from Your Home
In order to qualify for a HELOC loan, you must agree to use your home as collateral. Using your home as collateral makes it possible for lenders to give you a large credit line at a low interest rate. However, if you ever default on the loan, your home is at risk. If you do not pay back the HELOC, the lender may foreclose on the property.
One of the risks of removing equity from your home is that real estate market values fluctuate. If your home’s value declines, you may owe more money than your home is worth. For example, a homeowner purchases a home for $400,000. During a real estate boom, that property appraises at $600,000. If the owner takes out a HELOC for $200,000 (and uses the full limit), he then owes $600,000. Should the home’s value decline $100,000, the owner will owe $600,000 on a $500,000 home. He will not be able to pay off the HELOC by selling the property.
The real estate market will inevitably fluctuate. Before removing any equity from your home via a HELOC or other loan source, make sure you can pay the money back without selling your home.
HELOC Alternatives: Refinanced Mortgages and Home Equity Loans
Before you decide to apply for a HELOC, take the time to consider your alternatives. Homeowners that qualify for a home equity line of credit may also choose to liquidate their equity by refinancing their current mortgage or by taking out a home equity loan.
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Refinancing
Refinancing will give you an entirely new first mortgage. You’ll replace your original mortgage with new terms and a new interest rate. If your home appraises for more than the amount you currently owe on your mortgage, the lender may give you the difference. Refinancing your mortgage may be a smart choice if interest rates are down and you need a lump sum of money. The downside of refinancing your mortgage is that lenders often charge a lot in fees and points (money you pay up-front to lower your interest rate). Although it is possible to refinance your mortgage to a shorter term, many borrowers refinance with a new 30-year loan. If you want to own your home outright, adding an additional 30 years to the life of the loan may not be the best choice.
Home Equity Loans
Home equity loans are second mortgages that give borrowers an upfront sum of money for a fixed period of time (usually between 10 and 20 years). Borrowers with home equity loans generally have a fixed rate and know what their monthly bill will be ahead of time. Home equity loans are often more expensive than home refinances, but they do not require borrowers to change the terms of their original home loan. Because the interest rate monthly payment is known beforehand, home equity loans offer more peace of mind than HELOC loans. However, home equity loans do not have the same repayment flexibility as HELOCs. Borrowers with home equity loans must take a lump sum of money at one time and do not have a revolving line of credit to draw from.
How a HELOC Works
HELOC loans, on the other hand, provide a revolving line of credit. Like a credit card, you can draw money from your home equity line of credit whenever you choose. If you do not draw from the line, you do not have to make a monthly payment. Borrowers can generally use their HELOC during a 5-10 year draw period. After the end of the draw period, you will have to pay back the money you’ve borrowed. Some HELOCs require borrowers to pay back the money at the end of the draw period, some provide a 10-20 year repayment period, and some offer borrowers the opportunity to renew the line of credit for an additional term. All HELOC loans start out with adjustable interest rates, tied to the prime rate (the banks that currently lend to their most credit-worthy customers). Since the rate can change from month-to-month, HELOC borrowers do not know what their monthly payments will be before receiving the bill.