If you have equity in your home, you might consider tapping into it with a home equity line of credit. This second mortgage gives you access to your equity with low interest rates and costs, in many cases. While they are often easier to qualify for, they do have their downsides, though.

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Before you apply for a home equity line of credit, it’s a good idea to familiarize yourself with the downsides and how they pertain to you.

You Put Your Home at Risk

When you take out a home equity line of credit, you put your home on the line. Just like with your first mortgage, if you default on the loan, you can lose your home in foreclosure. In other words, the bank can come take your home from you in order to make good on your debt.

The reason that you take out the home equity line of credit will determine if this is a serious risk for you or not. Many people take out a HELOC to consolidate their consumer debt. A common example is people that are over their head in credit card debt. If you take the equity in your home to pay off the credit card debt, it can be freeing. But now your home just became at risk whereas with just the credit card debt, there wasn’t anything secured to the debt. If you didn’t pay your credit cards, the credit card company couldn’t take your home.

Before you take out a HELOC, it’s important to consider the reason to determine if you should put your home on the line or if there is another way to help your situation.

You Could Get in Over Your Head

A home equity line of credit isn’t like any other mortgage product out there. With the HELOC, you get a credit line. The bank gives you access to this credit line either with a checkbook or a debit card. You are then free to use the funds as you see fit.

You only pay interest on the funds that you withdraw. So if your credit line is $15,000, but you only use $5,000 of it, you only pay interest on the $5,000 that you used. You have the option to also pay back the principal if you want. If you don’t, you’ll start paying it back after the first 10 years that you have the credit line.

Here’s the downside. If you pay back the debt, you can reuse the funds until the first 10 years are over. In other words, you could have a large credit line at your disposal, encouraging you to use it when you otherwise might not have spent the money. This is the most common with borrowers that consolidate their debt into their HELOC. These borrowers often end up racking up their credit cards again because they are free. It also happens with borrowers that don’t pay off credit cards, but use the HELOC funds in another way, but pay the loan back early. They are often tempted to use the funds because the credit line is there and available for use.

You May Pay an Annual Fee

Many banks charge a fee, much like credit cards do in order to keep your credit line open. You need to read the fine print of the loan the lender gives you. Some lenders don’t charge a fee at all. Others charge one but only if you don’t withdraw a certain amount from your line of credit each year.

Knowing what the loan will cost you, aside from the interest is important. If it’s going to cost you a few hundred dollars per year and you are just going to let the money sit there, it’s not worth it. You are paying a fee for something that you don’t need.

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The Interest Rate is Variable

Most home equity line of credit loans don’t have a fixed interest rate. In other words, the rate can vary on a monthly basis. This means that when you do have money outstanding, you will never know what your exact monthly payment will be until you receive the bill.

It can be disconcerting to not know what your payment will be each month. While the interest rate won’t vary excessively, it will still vary. If you have a large HELOC balance, even a small increase in the interest rate can be difficult for you financially.

You May be Upside Down on Your Loans

As we all saw during the housing crisis, home values can fall and fall fast. There’s no way to predict if that will happen to us again. If it does and you have not only a first mortgage, but also a HELOC, you could find yourself upside down. This means that you owe more in mortgages than your home is worth. This could leave you stuck in your home for longer than you anticipated.

While lenders may offer a way out of an upside down loan, such as a short sale, it still affects you financially. It can also damage your credit. It’s wise to make sure that you keep your total outstanding loan-to-value at less than 80% of your home’s current value if possible to help prevent this situation from occurring to you.

You May not be Able to Deduct the Interest

If you enjoy deducting your mortgage interest on your taxes, you may be disappointed with your HELOC and inability to deduct the interest. The new tax law only allows you to deduct mortgage interest on a HELOC if you used the funds to improve the home.

If you used the funds for anything but home improvement, you cannot deduct the interest that you pay on the loan. While the rate may be lower than you would pay on a credit card, that’s about the only benefit you’ll see when you use a HELOC vs a credit card.

Before you take out a home equity line of credit, it’s important to look closely at the downsides of doing so. This isn’t to say that you can’t benefit from a HELOC, because many people can. You just need to give the loan amount, interest rate, and reason for taking the loan careful thought before making a decision.

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You have equity in your home so you think you can access it right away. That may not be the case, though. Some lenders and/or programs require a specific amount of seasoning. In other words, you must be in the home for a certain amount of time before you can access the equity. Some lenders also require a specific amount of equity before you can touch it, which is in line with the time requirement as it takes time to build equity.

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Just how long do you have to wait? Keep reading to find out.

The Amount of Equity

What lenders really care about is the amount of equity you have in the home. Typically, the magic number is 20%. Most loan programs require you to have 20% of the equity untouched. This gives lenders a cushion should you default on your loan.

This means that you can borrow as much as 80% of the home’s value, leaving 20% of the equity untouched. For example, if your home is worth $250,000, you can borrow up to $200,000. If you have a first mortgage with a balance of $150,000, you could still borrow up to $50,000 in a HELOC.

The Time

Most HELOC lenders don’t have a specific amount of time you must wait to take out a HELOC. Some may have the stipulation of six months to a year, but it typically takes at least that long to have enough equity in the home.

If you didn’t make at least a 20% down payment, it will take quite a bit of time to get to the point that you have more equity than the 20% cushion lenders require. At this point, time isn’t an issue, because it takes long enough to build up the equity. Lenders care more about the 20% equity requirement than how long you’ve been in the home.

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Other Eligibility Requirements for a HELOC

Seasoning isn’t the only requirement you must meet to get a HELOC. Yes, it’s a big part of it, but having 20% equity in the home isn’t the only requirement. You could have 20% equity and still not qualify for the loan.

Here’s what you need:

• Good credit – Second loans are risky for lenders. If you default on your payments, the first lender gets paid first. Second lienholders only get the money that is left, which oftentimes isn’t enough to pay them off in full. Having a good credit score helps balance out the risk, showing lenders that you’ll make good on your debts.
• Low debts – Lenders also look at your debt-to-income ratio. This compares your gross monthly income to your monthly debts. If your debts take up too much of your income, you pose a high risk of mortgage default. Keeping your debts low helps keep your DTI down, which increases your chances of approval.
• Stable employment – Lenders love to see borrowers with many years at the same job. Even if you changed jobs recently, if it’s within the same industry, it may help. Lenders need stability, knowing that you won’t change jobs often or be out of a job and unable to afford your mortgage payment.
• Assets – While it’s not a requirement, having assets on hand helps your chances of HELOC approval. If lenders know that you have money set aside for an emergency, they’ll feel better about your ability to pay your HELOC even if you lose your job or experience any other type of financial emergency.

HELOCs typically have flexible requirements, but the seasoning isn’t one they let go of very easily. Lenders need to know that there’s room in the home’s value should you experience a foreclosure. Having more than 20% equity in your home and having at least a year between when you bought the home and applied for the HELOC will give you the best chances at securing an approval.

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