A Home Equity Line of Credit (HELOC) can be dangerous and we descibe what to watch out for below.
Home Equity Line of Credit is abbreviated as HELOC. This refers to a loan in which the lender agrees to lend a maximum amount within an agreed period. This differs from standard loans or a reverse mortgage because the borrower is not advanced the entire sum up front, but uses the line of credit to borrow sums totaling no more than the amount.
A Home Equity Line of Credit in many ways is similar to a credit card. At closing you are assigned a specified credit limit that you may borrow up to (this is not a check).
A draw period usually lasts anywhere from 5 to 25 years and allows you to borrow HELOC funds whenever you feel the need; you’re only required to pay back the amount you use plus interest.
What’s nice about the home equity line of credit is that often, you are only required to pay the interest until the end of the draw period. At the end of the draw period, you’ll have to do one of the following:
- Pay back the full principal HELOC amount borrowed
- Pay a Home Equity Line of Credit balloon payment
- Pay based on a loan amortization schedule.
HELOC vs. Conventional Loan
HELOC’s differ from a conventional loans in that the interest rate on a home equity line of credit is variable depending on an index (Prime Rate for example). In plain terms, this means your interest rate will most likely change over time!
What makes a Home Equity Line of Credit so popular is that interest paid is usually deductible under federal and most state income tax laws; this makes that cost of borrowing money not as high!
Sounds easy, so why doesn’t everyone do it? Most people are doing HELOC’s and most can’t afford it! These people are considered to be Upside Down – a term used to describe someone who owes more on their home than it’s worth (much like a car :)
Here is the catch! You owe $80,000 on your home loan and your house is worth $90,000 on the open market. You decide to apply for home equity Line of Credit and the banker asks you what you would like the loan for – That’s right! Most of the time, you can ask for more than your home is worth, say $110,000 and almost always, you’ll get the loan.
$30,000 to Invest
Now you have $30,000 and live the life for awhile, perhaps a new boat, car or vacation. Then comes the day you need to sell your home but it’s only worth $90,000 and you need $110,000 plus the realtor fee of $7,700 (7%), so you put the house on the market for $117,700 and it never sells, payments become late and worse case scenario, you have a foreclosure on your hands! See for yourself, check out our Mortgage Calculator!
HELOC – Not always bad!
A Home Equity Line of Credit can be good or bad depending on how you use it. There are 10 things savvy home owners should look for when considering a Home Equity Line Of Credit:
1) No HELOC application fee or at least the fee should be refunded at closing. If your lender assesses an application fee, make sure it’s refundable at closing.
2) No home loan appraisal or closing costs – there are plenty of no-cost options available that you shouldn’t have to pay a HELOC appraisal fee.
3) No HELOC account maintenance or check-writing fees – Lenders already make money when you write checks (read – borrow) on the home equity credit line. If your lender tries this, dump him!
4) No “usage” fees – Apparently, HELOC lenders don’t approve of the notion that a homeowner may want to have a HELOC as an emergency “reserve” account. Definitely look for a lender that does not charge this type of fee.
5) Variable APR equal to or near the prime rate (adjusted quarterly) – Interest charged on the balanced borrowed should be the only cost involved with a good home equity credit line!
6) Periodic cap on interest rate changes (the amount that the rate can be changed at one time) – Look for a Home Equity Line of Credit that adjusts quarterly (rather than monthly) in increments of 0.5% or less.
7) Lifetime cap on rate increases (the amount that the rate can be adjusted over the loan’s life) – You’ll want to find a HELOC loan with a lifetime rate cap that you can live with. Ask your loan officer to clearly spell out the “worst case” scenario for HELOC rate increases!
8) Ability to convert to a fixed rate loan – When rates do rise, people often get skittish about their variable-rate debt. A useful feature to look for in a HELOC loan is the ability to convert the line of credit to a standard fixed-rate, fixed-term home equity loan.
9) Interest-only payments allowed – Get this option but only use it if you need to! It’s always best to pay down the principle, not just interest!
10) Unrestricted ability to repay principal without penalty – You should be able to pay off the Home Equity Line of Credit at any time without paying extra!
Enjoy these ten basic tips and now, more than ever, be careful! There are a lot of shady deals out there and if you don’t take your time reviewing the fine print, it will come back to bite you! Also make sure the pay close attention to any PMI that are presented.