A home equity line of credit, or HELOC, can be a convenient way to borrow against a home’s equity to pay for home renovation projects, college, debt consolidation or other major expenses.
Most lenders allow up to 80 percent of a home’s equity to be borrowed from the home’s value through a line of credit that can be accessed for up to 10 years through an adjustable-rate loan. Repayment can last for 10 to 20 years after the credit line term ends.
Like many financial tools, there are some potential pitfalls to look out for. Here are three to avoid with a HELOC:
Monthly Payments Can Rise
If interest rates rise, so will the monthly payments of a HELOC, which have adjustable rates. Rising interest rates will also increase the total cost of the amount borrowed, leading to a more expensive kitchen renovation, for example, than what you paid for initially.
A home equity loan with a fixed-interest rate may be a better alternative to a HELOC. Some HELOCs have fixed-rate options. A fixed rate is usually higher than a variable rate.
Interest-Only Payments Can Backfire
Some HELOCs allow interest-only payments on the amount borrowed during the first few years of the loan. This can make a loan cheap in the short-term if you plan to pay it back quickly. Over the long run, however, you’ll pay much more with interest-only payments early. You’ll face higher monthly payments later when the principal is due, which could include a balloon payment at the end of the loan term.
If your financial situation changes, or you haven’t budgeted for those higher payments, you could have difficulty making payments and could lose your house to foreclosure.
You May Be Tempted to Spend
With such a large credit limit on a HELOC, and payments that could be delayed for years, you may be tempted to buy things you normally can’t afford. The money from a HELOC looks just like any other money in your bank account, and it’s relatively easy to get if you have enough equity in your home.
A HELOC shouldn’t cost anything to set up, other than an annual fee of about $100 to have the money available to you. There’s also the good news that the interest payments on a HELOC are tax deductible, just as mortgage interest is.
But using a HELOC for anything other than a home improvement could lead you to thinking its free money to be spent however you like. Having thousands of dollars at your fingertips takes discipline. Be sure you have some in storage before getting a HELOC.