A home equity line of credit (HELOC) might seem like a good idea if you're a homeowner who to make extra cash. However, you should be aware of some risks when applying for a HELOC.
Since this is your home on the line, it's important to walk into the transaction with your eyes wide open. We'll explore some of the ways a HELOC could hurt your financial situation.
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Your home is at risk
When you take out a HELOC, the line of credit is secured by your home equity. If you aren’t able to keep up with the monthly payments on your HELOC, the lender could foreclose on your home.
Of course, losing your home is a worst-case scenario. But it’s important not to stretch your budget too far when leaning on a HELOC.
Your credit score can take a hit
When you open a new line of credit, your credit score tends to drop by a few points. Making late payments to your HELOC or choosing to use a large portion of your credit line could also lower your credit score.
On the flip side, making on-time monthly payments on your HELOC can improve your credit score. A HELOC can actually help your credit score in the long run if you use it responsibly.
You face upfront costs
Most HELOCs come with closing costs, which might include a home appraisal and origination fees. If you don’t factor in closing costs, these expenses could make the loan surprisingly expensive.
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The interest rate may increase
HELOCs usually have variable interest rates, which means the interest rate can change over time. Since the interest rate can rise and fall, a rising rate can make it more expensive to carry the debt.
The good news is that most HELOCs have a maximum rate attached. But if the maximum interest rate is 25%, that leaves a lot of room for your interest rate to climb.
If you are using the HELOC to pay off your debts, a rising interest rate could make this move more expensive than you originally expected.
A fluctuating monthly payment can wreak havoc on your budget
As the interest rate of your HELOC rises and falls, your monthly payment will change with it. Unfortunately, a changing monthly payment may make it difficult to manage your monthly budget.
If you have a tight budget, a rising HELOC payment could put significant pressure on your finances. For homeowners who want to tap into equity with a fixed monthly payment, consider a home equity loan instead.
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Sticking to interest-only payments might hurt later
HELOCs typically have two periods: a draw period and a repayment period. During the draw period, you can tap into the funds when you need them.
Along the way, the lender might allow you to make interest-only payments. But when the draw period ends, you’ll be expected to repay the principal and interest.
The ability to make interest-only payments might give you some breathing room in your budget upfront. But when you hit the repayment phase, you might regret the decision because you’ll be facing a larger monthly payment.
Depending on your situation, the large payment could impact your budget in a big way.
Easy to spend more than you should
A HELOC gives you the ability to tap a line of credit on an as-needed basis. While the flexibility of a HELOC might be good for some, it can act as a source of temptation for others. After all, it’s easier to overspend if you have easy access to the funds.
Evaluate your own spending habits before taking out a HELOC. If you aren’t sure that an open-ended line of credit is a good idea, consider a home equity loan instead.
Your home’s value could fall
Although you might expect your home’s value to rise, the reality is that it could fall. If your home value declines, you could end up owing more than your home is worth.
For example, if your home mortgage balance is $200,000 and your HELOC balance is $30,000, you owe $230,000 in total. If your home value drops from $280,000 to $200,000, then you suddenly owe more than the home is worth.
When you want to sell your devalued home, the lenders expect you to pay off the mortgage and the outstanding HELOC. Coming up with tens of thousands of dollars could be a financial disaster.
Bottom line
A HELOC offers one way to borrow against the value of your home. But when you put your home on the line, there are risks to your financial health that you can’t afford to ignore.
If you need cash, you might explore other options, such as home equity loans and personal loans.
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