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.