How not to use a HELOC
The current housing boom has often been frustrating for buyers, but if you already own your home, this presents an opportunity.
Higher home values – prices have gone up more than 20% year over year in April – means more equity, against which you can borrow money at a relatively low interest rate.
Just because you can borrow against the equity in your new home doesn’t mean you should. A home equity line of credit, or HELOC, might sound like a great idea for homeowners, and it has benefits, but it also comes with risks. Experts say some uses are better than others.
Before applying for a HELOC, think twice about how you plan to use one and explore other alternatives.
What is a HELOC?
As a homeowner, you may have accumulated equity in your home, which means that its current value is more than what you owe on your mortgage. Depending on how much equity you have, you may be able to borrow with a HELOC.
A HELOC is a revolving line of credit rather than an installment loan, like a traditional home equity loan. It works much like a credit card; the lender gives you a credit limit, and you can use it repeatedly – up to the maximum credit limit. Bruce McClarySenior Vice President Membership and Communications with the National Credit Counseling Foundationsaid HELOCs have some advantages over other forms of credit.
“A HELOC gives homeowners the flexibility to borrow as needed during the drawdown period and within the available credit limit,” he said. “It gives the borrower more control over when and how much will be borrowed.”
Before getting a HELOC, make sure you can repay a loan on the full line of credit. This will protect you from the financial danger posed by overspending.
HELOCs are secured lines of credit that use your home as collateral. “Because a HELOC loan uses the home as collateral, interest rates are more competitive than unsecured lines of credit,” McClary said.
Because they’re secure against your home, HELOCs can be risky, says Madison BlockSenior Communications Officer at American consumer credit counseling, a non-profit credit counseling agency. “A major risk of a HELOC is that your home is the collateral,” she said. “You’re also reducing the equity in your home, so if house prices go down, you could end up owing more than your home is worth.”
During the HELOC draw period, you only make payments on accrued interest. Once the draw period is over, you make payments against interest and the amount of credit you used.
Why You Shouldn’t Use a HELOC
Unlike some other forms of debt, HELOCs have no restrictions on their use; you can use the line of credit to pay for various expenses. Because of the risks associated with HELOCs – that you could lose your home if you don’t repay the debt – experts say you should think twice before using a HELOC for the following expenses:
It can be tempting to use a HELOC to consolidate high interest credit cards or other debts due to their low interest rates. However, this can be a dangerous choice.
Debts like credit cards, personal loans and student loans are unsecured; if you fall behind on your payments, it will hurt your credit and you may end up in collections, but your property is safe. In contrast, a HELOC is secure. Going from unsecured debt to secured debt can be dangerous because you risk losing your collateral. In this case, that means your home.
“One of the most compelling reasons to use a HELOC to consolidate credit card debt is low interest rates, but this is another situation where the stakes rise when unsecured debt becomes guaranteed,” McClary said.
Also, using a HELOC to consolidate debt doesn’t solve the problems that got you into debt in the first place. In fact, it could lead to even more debt.
Instead, explore other options like personal loans or balance transfer cards.
“An alternative to consider would be a balance transfer to a low-interest card or an interest-free introductory offer,” McClary says. Or consider meeting with a nonprofit credit counselor for personalized advice.
Unfortunately, vacations aren’t an essential expense, no matter how much you want to be away from work. If you’re considering a HELOC as a low-interest way to finance a dream vacation in Europe or a cruise, know that going into debt for non-essentials is rarely a good idea. Worse still, HELOC rates are typically variable, meaning they change over time. Depending on the lender, the maximum rate may be higher than 20%.
With a HELOC, you can get low upfront payments during the draw period. But once repayment begins and you need to make principal and interest payments, rising interest rates can dramatically increase the amount of your payments and force you to repay much more than you originally borrowed. .
Instead, focus on cashing out your dream vacation by creating a budget and savings plan. It may take a while, but being able to pay cash for your vacation can be worth it.
When you buy a car with a HELOC, you use your home as collateral. And you risk fluctuating interest rates, so your payments could increase significantly.
If you have good credit — or know someone willing to co-sign a loan application — you can probably get a car loan with a relatively low interest rate and fixed monthly payments. In fact, the average rate on a new car loan with a 72-month term was just 4.55% in February, which is favorable relative to HELOCs.
Although HELOCs may seem like a cost-effective financing option for colleges, federal student loans are probably a better bet. There’s no way to defer HELOC payments if you lose your job or get sick, and there’s no potential for loan forgiveness.
Unlike HELOCs, federal student loans offer more protection. You can enroll in an income-driven repayment plan if you can’t afford your payments, defer payments through federal forbearance or deferment programs, and even qualify for Cancellation of civil service loans if you work for a non-profit organization or a government agency.
With relatively low rates, the idea of using a HELOC to get money to invest in the stock market or cryptocurrency can be appealing. However, this is an incredibly risky strategy.
There is no guarantee of return with any investment; you still risk losing money. Even if you choose relatively safe securities, there is no market control and your investment could lose value. If this happens and your HELOC repayment period begins, you may run out of money and be unable to pay your payments.
Instead, focus on investing the money you have, not the money you borrow. Set aside money from every paycheck to invest, or consider using windfall gains like a tax refund to invest in the stock market.
Why should you use a HELOC
While there are some risks associated with HELOCs, there are certain scenarios where they can make sense. A HELOC can be a good choice for the following expenses:
Using a HELOC for home renovations is one of the most common purposes. By making repairs or remodeling the house, you could make it a more livable home. Or you can do renovations that improve its resale value, so you can use a HELOC to actually build more equity. As an added benefit, the interest you pay on the HELOC may be tax deductible.
“If you can afford the payments, a HELOC can be a great way to fund home improvements because you can get a tax advantage,” Block said.
However, be aware that you are unlikely to get a dollar-for-dollar return on your home renovation costs. According to Homelight, the average return for popular renovation projects is only 60%. With this information in mind, only complete projects that are necessary to make a sale – or that make staying in your current home more appealing. Home improvement projects are probably less expensive than moving.
If you have a medical bill that wasn’t covered by insurance or an upcoming necessary procedure, a HELOC might be a helpful option. It has relatively low rates and a long repayment term, giving you more affordable payments. Medical procedures required to maintain or improve your health are a good use of your home equity; Just make sure you have a plan in place to pay off your debt.
A HELOC can be a great way to get money for necessary expenses. However, it is important to be aware of the risks associated with using this type of credit. Your home serves as collateral, so the lender can foreclose on your home if you miss payments. And with fluctuating interest rates, your rates – and your monthly payments – can go up.
In general, it’s a good idea to only use HELOCs for essential expenses, expenses that will improve your net worth or are necessary for your health. Home renovations that increase the value of your home and medical expenses are generally justifiable uses for HELOCs, while non-essential expenses tend to be riskier uses.
If you decide to borrow against your capital, do your homework beforehand.
“Check your credit to see where you stand before entering the market,” says McClary. “Also, make sure you’re able to affordably repay a loan on the full line of credit, even if you don’t expect to use it all.”