Home equity lines of credit (HELOCs) is a kind of second mortgage that offers homeowners the ability to borrow money against the collateral of their home.
If you’ve lived in your home more than a couple of years, you likely have enough equity to apply for a HELOC. A HELOC works similar to a credit card because it gives you a credit limit and you can take out money in increments rather than a home equity loan, which gives you all the money at once.
HELOCs can be a great option when you need to pay for college, medical expenses and home improvement projects. But this form of borrowing doesn’t suit everyone, and you should consider the pros and cons before you sign up for one.
If you have an ordinary home equity loan, you get a lump sum, and then make the same payments each month, much as you do for your mortgage. But, as its name implies, a HELOC gives you a line of credit: you can borrow as much (up to your limit) or as little as you wish, as your circumstances change, and your payments should vary each month depending on the amount you then owe. It’s a bit like a credit card in that respect.
It may work a bit like a credit card, but, depending how you use it, it’s unlikely to cost as much as one. Because you’re using your home as security for the loan, your lender has a much lower risk of making a loss if you get into financial trouble. So it can generally charge much less in interest than current credit card rates. To make HELOCs even more affordable, many lenders offer introductory teaser rates, often for the first six months you have your line of credit.
Pro and con: Debt consolidation
If you’re paying high rates on a number of large credit card balances or other loans, you can significantly reduce your monthly outgoings by zeroing them with a HELOC. That can be a good idea if you’re financially strong again after some problems, but it also has drawbacks. Most importantly, you’d be turning unsecured debt (which you could discharge in bankruptcy) into secured debt, which would see you lose your home if you fall far behind with payments. That’s why many counselors caution those whose financial circumstances remain perilous against using secured debt to pay down unsecured obligations.
Pro and con: Rates risk
Many consumers choose adjustable-rate HELOCs because they’re almost always initially cheaper than fixed-rate ones. But we’re in a period when interest rates are still very low and generally trending upward, and some economists think they could rise quite steeply in coming years. In its downloadable PDF, “What You Should Know about Home Equity Lines of Credit,” federal regulator the Consumer Financial Protection Bureau notes that lenders have a statutory obligation to cap the maximum possible rate rise for each HELOC. However, before you sign it, you should check your loan agreement to see how high your rate could go, and then work out whether you’d struggle to make payments if the worst happens. That initially more expensive fixed-rate option may look more attractive.
Con: Closing costs
One way in which HELOCs are more like mortgages than credit cards is that you have to pay closing costs. These are, according to the Federal Trade Commission, likely at the very least to include application, attorneys’ and appraisers’ fees, a title search charge, and “points.” You’ll remember points from your mortgage: they’re a percentage of the amount you borrow, and your lender should tell you what that percentage is right at the get-go. One important consideration for those tossing up between a HELOC and a home equity loan: All those closing costs are rolled up into the annual percentage rate (APR) you’re quoted for the straight loan, while you have to pay the closing costs AND the APR on a HELOC. So you can’t directly compare the two APRs.
Hang on, you’re thinking: In point 2 (above), he was saying how cheap HELOCs are. Now he’s warning about their costliness. The thing is, they can be either, depending on how you use them. It’s those closing costs that make the difference. If you use your line of credit a lot, then it is usually a cheap form of borrowing, especially compared with credit cards and unsecured personal loans. However, if you hardly ever use it, and then for only small sums, all those fees, charges and points could make the total cost of borrowing such small amounts very expensive indeed, and you might be better off with low-interest credit cards.
Pros, cons and you
As long as you fully understand the pros and cons of HELOCs, and recognize how they apply to your personal circumstances, this form of borrowing can be very attractive. However, it isn’t risk free. The collapse in house prices that followed the credit crunch illustrates that this — like all borrowing — requires you to make cool calculations about benefits and risks.
One last thing: You must make sure that the deal you sign up for is one that best suits your needs. Lenders’ offers on HELCOs vary enormously, and it really is important that you shop around to find the one that’s ideal for you.