Following the 2008 housing market crash, many Americans are wary of any loan collateralized against their homes. While this is an understandable concern for some, many Americans would actually benefit from acquiring a Home Equity Line of Credit for use in times of financial need. Providing a quick, relatively large cash pool, HELOCs tend to outperform credit card loans in terms of debt management when utilized properly.
To understand the potential benefits of HELOCs, it is important to note how they differ from typical mortgages. Home Equity Lines of Credit are, as the name suggests, lines of credit rather than loans. This means that there is a maximum allowable loan, often no minimum draw, and interest is only paid on money borrowed. If you do not end up drawing against the line of credit, you do not pay any interest expense. Most HELOC’s have a variable interest rate, rather than the fixed rate of a typical mortgage. This rate is tied to the market interest rate, which can mean trouble if interest rates rise. Finally, if the money is used for home repairs and upgrades, the interest accrued on it is tax deductible.
That is not to say that a HELOC is right for everybody. They have some of the same closing costs as a first mortgage (application and appraisal fees, attorney’s fees, etc.) which can add up quickly. This means that HELOCs are probably not right for anyone unable to make a fairly large initial payment, or who are seeking to borrow a relatively small amount of money. They are also a bad choice for anyone who cannot afford for interest rates to rise, or who does not expect to be able to keep up with their monthly payments. In a worst case scenario, the issuer of the HELOC can force the homeowner to foreclose on their home if they borrow too much and fail to pay it back.
Debt consolidation is also a terrible reason to take out a HELOC, especially without a strict debt management plan. While the idea of debt consolidation may appeal to many borrowers, the true change needed to reduce debt is usually behavioral. Without a strict behavioral plan for reducing debt, paying off other loans with a HELOC does nothing to lessen the burden; it only shifts it. Furthermore, if the existing debts are not related to the acquisition or maintenance of the home, the HELOC interest paid may even lose its tax-deductible status. For more information on the deductibility of HELOC interest, consult a tax preparer.
For anyone else, however, especially those looking to take out a loan to do maintenance on their house, a HELOC might be perfect. Since the credit uses your home as collateral, the initial interest rate is usually much lower than the rate on a typical credit card. A HELOC that is arranged in a time of prosperity can also serve as an emergency backup fund if a homeowner’s financial situation takes a serious turn for the worse. By opening a HELOC when their credit score is high, a homeowner can usually receive a low initial interest rate. They can then borrow at that rate later if they need emergency funds, rather than borrowing at outlandishly high credit card interest rates. While the rate is variable, and will likely be adjusted upwards in a time of financial struggle, there are periodic and lifetime caps on how high it can increase.