How a Home-Equity Line of Credit (HELOC) Can Hurt You
August 20, 2019
If you don't manage your home-equity line of credit prudently, a HELOC can become very expensive and get you into financial trouble.
Because home-equity lines of credit generally have variable interest rates, rising interest rates can increase monthly payments and total borrowing costs. The interest rate is based on a benchmark rate, such as the Fed funds rate, plus a margin, which is established by the lender. When interest rates go up, your monthly payment will go up.
As a result of item number 1, having a HELOC is similar to having an adjustable-rate mortgage in that your monthly payments can change significantly when interest rates change. It can be difficult to budget or make future financial plans when you cannot predict your monthly payments or your total borrowing costs.
Some HELOCs have an option that allows you to make interest-only payments on the money you borrow during the first few years of the loan term. Interest-only payments seem great in the short term because they allow you to borrow a lot of money at what appears to be a low cost. In the long run, the picture is not so rosy. Borrowers face dramatically higher monthly payments once the interest-only period expires, and possibly a balloon payment at the end of the loan term.
A low-interest HELOC can seem like a great way to consolidate high-interest debt, like credit card bills. It can even seem like a great way to refinance any debt with a higher interest rate than the HELOC rate, like a car loan. When you extend your repayment terms from a few years to as many as 30 years, however, the overall cost of your debt may increase even if your interest rate is significantly lower. Another problem is that HELOC interest rates are variable. You might be refinancing at a lower rate now, only to have that rate increase. When the rate increases, you may no longer be coming out ahead.
A HELOC costs little to nothing to establish, and the annual fee to have the funds available is usually no more than $100. Furthermore, accessing the money is as simple as writing a check or using a debit card. When you have tens of thousands of dollars readily available and spending it feels just like making any other purchase, it can be easy to rely on a HELOC to pay for purchases that your monthly income can't cover.
These potential problems are discussed in more detail in this article. If you are over the age of 62, you might consider a reverse mortgage as an alternative.