5 Ways a Home Equity Line of Credit (HELOC) Can Hurt You

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5 Ways a Home Equity Line of Credit (HELOC) Can Hurt You

You may have heard that a home equity line of credit (HELOC) is a convenient, flexible, and low-cost way to borrow money. All these statements can be true if you manage your HELOC prudently. Taking out a HELOC, rather than a home equity loan, means that you only pay interest on the amount of the line of credit that you’re actually using, rather than on all the money that you are eligible to borrow.

But if you aren’t careful, a HELOC can become very expensive and get you into financial trouble. Here are five ways that a HELOC can hurt you.

Key Takeaways

  • The typical interest rate on home equity lines of credit (HELOCs) is variable, which might potentially result in larger monthly payments.
  • When the interest-only term ends, HELOC borrowers who first make interest-only payments will have drastically higher monthly payments.
  • For those without sound money management skills, using a HELOC to consolidate debt might be problematic.
  • HELOCs might provide the impression that living above one’s means is quite simple.

1. Rising Interest Rates Affect Monthly Payments and Total Borrowing

HELOCs generally have variable interest rates. The interest rate is based on a benchmark rate, such as the federal funds rate, plus a margin, which is established by the lender. When interest rates go up, your monthly payment will go up, too.

There is no way to predict when increases will happen or how much they will be. Your new monthly payment could be unaffordable. Getting behind on those payments can lower your credit score—not to mention increasing the interest that you owe. The fine print of your HELOC should state a maximum possible interest rate. However, if your current interest rate is 6% and the maximum is 20%, that information will not be very comforting.

Interest rates also affect your long-term total borrowing costs, not just your monthly payments. If your HELOC’s interest rate increases before you pay it off, the total cost of what you borrowed the money for goes up. A larger interest payment also means that you have less money for other things, such as paying bills or saving for retirement.

Home Equity Loans

Getting a fixed-rate home equity loan as opposed to a HELOC is one strategy to mitigate the risk of rising interest rates. According to Marguerita Cheng, CEO of Blue Ocean Global Wealth, “In a rising-interest-rate climate, it may be wiser to have a home equity loan to lock in a fixed rate.” Utilizing the fixed-rate option that certain HELOCs provide is an additional alternative.

  Mortgage Amortization Strategies

You typically pay a little higher interest rate than you would on a variable-rate HELOC in return for the security of a fixed rate. This dynamic is comparable to the difference in interest rates between fixed-rate mortgages and adjustable-rate mortgages.

The draw term of the majority of HELOCs allows you to use your available credit and make modest, often interest-only payments throughout that time. The loan enters the repayment phase when the draw time is over.

2. Fluctuating Monthly Payments Can Cause Financial Instability

Your monthly payments with a HELOC might vary greatly when interest rates fluctuate, much as with an adjustable-rate mortgage. When you are unable to forecast your monthly payments or overall borrowing expenses, it may be challenging to create a budget or establish long-term financial planning.

Naturally, some borrowers feel comfortable taking on this degree of risk, particularly in conditions with low interest rates. A home equity loan or a HELOC with a fixed rate, however, can be a better alternative if you want a lower amount of risk in order to sleep well at night.

In the words of Tri-Star Advisors’ Jonathan Swanburg, an investment advisor representative: “Variable-rate loans are a fantastic option if you are looking for low rates over the short term and could easily afford to quickly pay down the loan (or pay a significantly higher interest expense should interest rates rise). But all too often, people utilize the money they save from their floating-rate loans to upgrade their lifestyle by buying additional vehicles, clothing, or vacations. As a result, when interest rates increase, they can no longer pay the interest charge and run into financial difficulties.

During the 2020 economic crisis, several banks stopped accepting applications for HELOCs, and they still don’t.

3. Interest-Only Payments Can Come Back to Haunt You

You may be able to make interest-only payments on the money you borrow during the first years of the HELOC thanks to a certain choice. Short-term benefits of interest-only payments include the ability to borrow a large sum of money at what seems to be a cheap cost.

  Satisfaction of Mortgage Definition

Long-term, things are not looking so well. Once the interest-only phase is over, the monthly payments for borrowers will be much higher, and they may also be subject to a balloon payment at the conclusion of the loan term. You may not be able to make the larger payments if you don’t budget for these increases—or if your financial condition remains the same or becomes worse.

Additionally, when you pay a loan’s interest simply, the principle is left unpaid. You’ll have to make debt payments for a longer period of time if you put off paying down the principle. Naturally, you must pay off the principle of your loan before you can repay it.

You only pay interest on the amount you borrow with a HELOC. You will thus pay interest on $10,000 if your borrowing limit is $30,000 but you only borrowed $10,000.

4. Debt Consolidation Can Cost More in the Long Run

Consolidating high-interest debt, such as credit card payments, may seem like a wonderful idea when done with a low-interest HELOC. Even refinancing debts like vehicle loans that have higher interest rates than the HELOC rate may seem like a smart idea.

Even though your interest rate is much lower, the total cost of your loan might rise if you expand your payback periods from a few years to as many as 30. Before making this decision, you should utilize an online debt consolidation calculator to see whether you would benefit.

The fact that HELOC interest rates fluctuate is another another issue. If you refinance today at a lower rate, the rate may rise in the future. You can find yourself losing money if the rate rises.

HELOC debt consolidation might be problematic for those who lack sound money management. After paying down their credit card bills with HELOC funds, these folks often increase them again. The issue they were seeking to tackle then becomes more complicated as a result of their increased debt levels.

5. Easy Money Facilitates Spending Beyond Your Means

Establishing a HELOC costs next to nothing. Additionally, much like mortgage interest, interest payments are tax deductible in certain situations. And to top it off, getting your hands on the cash is as easy as writing a check or using a debit card.

  Benefits Of Paying Off Your Mortgage

With HELOCs, you have access to tens of thousands of dollars, and making purchases with them is the same as making any other transaction. In these circumstances, it may be simple to depend on a HELOC to meet expenses that your monthly income does not permit.

It’s risky to develop the habit of living beyond your means. It depletes your funds and makes it more challenging to survive if your financial condition worsens.

How much can I borrow with a home equity line of credit (HELOC)?

Property equity lines of credit (HELOCs) typically allow you to borrow up to 85% of the equity in your home. The borrowers will also need strong credit ratings.

How do I calculate home equity?

It is simple to determine your home’s equity. The market value of the property is obtained by deducting the mortgage debt from it. The equity of a property, for instance, is $250,000 if it is worth $550,000 and you loan $300,000.

Can I lose my home if I don’t make HELOC payments?

Your house is used as collateral to acquire a HELOC. Your house may be repossessed by the lender if you don’t make your payments.

The Bottom Line

Only finance items that will help your financial status over the long term. “HELOCs may be quite beneficial if exclusively utilized for housing costs. The greatest options include remodeling or house upgrades, according to Harbor Wealth Management founder Elyse Foster. Aside from that, you should live within your means to avoid incurring debt to pay for emergencies.

Avoid getting into problems if you decide to take out a HELOC.

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