How 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 of these statements can be true if you manage your HELOC prudently.
But if you don't, a HELOC can become very expensive and get you into financial trouble. Here's how.
Rising Interest Rates Can Increase Monthly Payments and Total Borrowing Costs
HELOCs generally have variable interest rates. The interest rate is based on a benchmark rate, such as the Fed funds rate, plus a margin, which is established by the lender. When interest rates go up, your monthly payment will go up.
There's no way to predict when increases will happen or how much they will be. Your new monthly payment could be unaffordable, and getting behind on your payments can lower your credit score – not to mention augmenting the amount of interest you owe. The fine print of your HELOC should state a maximum possible interest rate, but if your current interest rate is 6% and the maximum is 20%, that information isn't going to be very comforting.
Interest rates also affect your long-term total borrowing costs, not just your monthly payments. If the interest rate on your HELOC increases before you pay it off, the total cost of whatever 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. (For more on this, check out "The Beauty of Budgeting.")
One way to combat the risk of higher interest rates is to take out a home equity loan, which has a fixed rate, instead of a HELOC. "In a rising interest-rate environment, it may be better to have a home equity loan to lock in a fixed rate," says Marguerita Cheng, CFP®, CEO, Blue Ocean Global Wealth, Gaithersburg, Md. Another option is to take advantage of the fixed-rate option that is offered with some HELOCs.
However, in exchange for the certainty of a fixed rate, you'll generally pay a slightly higher interest rate than you would on a variable-rate HELOC. This dynamic is similar to the one that exists between the interest rates for adjustable-rate mortgages and fixed-rate mortgages.
Fluctuating Monthly Payments Can Cause Financial Instability
Having a HELOC is similar to having an adjustable-rate mortgage in that your monthly payments can change significantly when interest rates change. It can be difficult to budget or make future financial plans when you cannot predict your monthly payments or your total borrowing costs.
Of course, some borrowers are comfortable taking on this level of risk, especially in low interest rate environments. But if you need a lower level of risk to sleep soundly at night, a home equity loan or fixed-rate option on a HELOC may once again prove to be a better choice. (For a better understanding on home equity loans, see "Home-Equity Loans: The Costs.")
"Variable rate loans are a terrific 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," says Jonathan Swanburg, investment advisor representative, Tri-Star Advisors, Houston, Texas. "However, far too often, individuals take the savings from their floating rate loans and use them to increase their lifestyle by spending more on cars, clothes or travel. Consequently, when rates rise, they can no longer afford the interest expense and find themselves in financial trouble."
Interest-Only Payments Can Come Back to Haunt You
Some HELOCs have an option that allows you to make interest-only payments on the money you borrow, during the first few years of the loan term. Interest-only payments seem great in the short term because they allow you to borrow a lot of money at what appears to be a low cost.
In the long run, the picture is not so rosy. Borrowers face dramatically higher monthly payments once the interest-only period expires, and possibly a balloon payment at the end of the loan term. If you don't budget for these increases, or if your financial situation stays the same or worsens, you may not be able to afford the higher payments.
Plus, when you only pay the interest on a loan, the principal remains. The longer you wait to start paying off the principal, the longer you'll be making debt payments. And of course, you can't pay off your loan until you pay off the principal. (For more details, read "Interest-Only Mortgages: Home Free or Homeless?")
Debt Consolidation Can Cost More in the Long Run
A low-interest HELOC can seem like a great way to consolidate high-interest debt, like credit card bills. It can even seem like a great way to refinance any debt with a higher interest rate than the HELOC rate, like a car loan.
When you extend your repayment terms from a few years to as many as 30 years, however, the overall cost of your debt may increase even if your interest rate is significantly lower. You'll want to use an online debt consolidation calculator to determine whether you'll come out ahead before considering this move.
Another problem is that, again, HELOC interest rates are variable. You might be refinancing at a lower rate now, only to have that rate increase. When the rate increases, you may no longer be coming out ahead.
Debt consolidation with a HELOC can also cause problems for people who lack financial discipline. These people tend to run up their credit card balances again after using the HELOC money to pay them off. Then, they end up having more debt than they started with, and the problem they were trying to solve grows into a larger problem. (For more on this subject, check out "Debt Consolidation Made Easy.")
Easy Money Can Facilitate Spending Beyond Your Means
A HELOC costs little to nothing to establish, and the annual fee to have the funds available is usually no more than $100. Furthermore, interest payments are tax deductible, just like mortgage interest, and accessing the money is as simple as writing a check or using a debit card.
When you have tens of thousands of dollars readily available and spending it feels just like making any other purchase, but with tax benefits, it can be easy to rely on a HELOC to pay for purchases that your monthly income can't cover.
Getting into the habit of living beyond your means is dangerous. It eats away at your savings and makes it extra difficult to get by if your financial situation changes for the worse (say, because you lose your job).
The Bottom Line
You should only borrow money for purchases that will improve your financial situation in the long run. "HELOCs can be very valuable if used for housing expenses only. Remodel or home improvements are best," says Elyse Foster, CFP®, principal, Harbor Financial Group, Inc., Boulder, Colo. Other than that, you should live below your means so you can cover emergencies without going into debt, and provide for yourself when you're unable to work.
If you decide to take out a HELOC, don't let it get you into trouble.