HELOCs offer attractive features, but they’re not for everyone

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December 28, 2015 | Updated September 19, 2017


Key Points

HELOC pros and cons

  • HELOCs can be a convenient source of money and are backed by home equity.
  • They are more flexible than traditional second mortgages and often have fewer upfront costs.
  • HELOCs have variable rates and are subject to considerable interest rate risks.

A home equity line of credit (HELOC) has proven to be a useful loan product for many Americans seeking to avert a financial stress or calamity. And let’s face it, the average American can easily find themselves in dire straits on that front.

A person may get smacked with a big medical expense or a large car repair bill. A HELOC can provide a convenient source of cash for addressing those woes — perhaps a better option than maxing out high-interest credit cards or even taking out a traditional second mortgage.

A HELOC is typically structured like a second mortgage, but it is not exactly a normal loan.  With a traditional home equity loan, the money comes in a fixed lump sum, which needs to be paid back over a period, like a traditional primary mortgage.

A HELOC is more like a credit card backed by the built-up equity in a house. The lender promises to give the borrower a fixed amount of money over time, but the borrower is usually free to decide how much they want to borrow. It’s a revolving line of credit, where the borrower spends money from the account, and pays money back on a set schedule.

HELOC phases

HELOCs have two phases. In the first, which typically lasts five to 10 years, the borrower can make draws on the line and pay interest only on the average daily balance of the drawn amount.

In the second phase, a period of usually 10 to 20 years, the borrower begins to pay down the principal amount equal to the balance at the end of the draw period.

Normally, the principal is paid back in monthly installments. Some HELOCs, however, might feature balloon payments or need to be paid off entirely or refinanced at the end of the draw period.

HELOC perks and risks

HELOCs carry some advantages. A HELOC is more flexible than a traditional second mortgage. A HELOC is especially appealing to homeowners who may want to draw on the money in smaller bits, or want the security of a cash cushion for emergencies. The borrower is only paying interest on the drawn amount. HELOCs also typically have fewer upfront loan costs than standard second mortgages.

Equity lines carry risks, however. One of the biggest risks involves the interest rate. The rates on HELOCs are variable, and potentially more volatile than traditional adjustable-rate mortgages.

HELOC rates are usually tied to the prime rate and adjusted by the day. A HELOC follows closely the movements of short-term interest rates. The Federal Reserve, the nation’s central bank, manipulates the benchmark short-term rate. So when the Fed decides to raise rates rapidly with a series of short-term interest rate hikes, as they have done several times in the past, it can push up the HELOC rates dramatically.

HELOC flavors

During the extended period of low interest rates after the most recent downturn in 2008, borrowers with HELOCs made out well. The prime rate remained stable and historically low for years.

In a rising interest rate environment, however, HELOC borrowers typically experience higher interest payments. Over a period of 15 to 20 years, the prime rate typically bounces around significantly. That’s why many originators recommend that borrowers look first at the more stable home equity loan products when planning major, one-time improvements or repairs to their homes.

As with other loan types, however, not all HELOCs come in the same flavor. For example, some HELOCs can be turned into fixed-rate loans after the initial draw period ends, which would be attractive to the borrower of a large sum of money. Some lenders also impose additional costs on the borrowers that can push up the rates, and lenders also sometimes impose minimum draw limits and prepayment penalties.

It pays for borrowers to shop around for the best HELOC option.

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