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A home equity line of credit (HELOC) is becoming increasingly popular as home values rise. But is getting one a good idea?
Usually, no, people tend to forget about the housing bubble when many were left upside-down in their loans.
A HELOC does have some sensible uses, like improving the value of your home. It can be a viable option depending on your financial situation and what you plan to use the funds for.
But if you use it to make purchases that you can’t afford, it’s considered bad debt.
What is a HELOC, and Is it Worth Getting One?
A home equity line of credit allows you to borrow against the equity in your home. You’ll usually be able to borrow up to 85% of your home’s value.
How much you can borrow is contingent on your credit, your debt to income ratio, and the financial institution.
Your home is used as collateral, so you may lose it to a foreclosure if you fail to make payments.
A HELOC is somewhat similar to a credit card because it is a revolving line of credit. It has two different periods, first the draw period then the repayment period.
During the draw period, it acts as a revolving line of credit. You have full use of the credit line, and you’re only required to make minimum payments (usually interest only). Most draw periods are ten years long.
During the repayment period, the line of credit is closed, and you must pay back the balance.
The minimum payment is higher because of the addition of the principal. The duration of the repayment period is usually 20 years.
The terms and conditions of a HELOC vary depending on the financial institution.
Common Uses for a HELOC
Having worked as a home equity and mortgage underwriter, I’ve seen several different uses for a HELOC.
Some of the most common uses are debt consolidation, home improvement, emergency funds, and purchasing real estate.
Is getting a HELOC for these reasons a good or bad idea? Well, these uses are considered correct and not really a misuse of a HELOC. Let’s dig deeper with more details.
Many Americans wind up getting overburdened with high-interest debt. Using a HELOC to consolidate debt can provide some relief.
In most cases, HELOCs have lower interest rates and payment obligations.
Debt consolidation with a HELOC may be a good idea if you are capable of repaying the loan.
Keep in mind during the draw period, the minimum payment usually only goes towards interest.
While you may free up your cash flow, you’re not paying down any debt.
You could end up staying in debt longer unless you make additional payments towards the principal.
Improving the value of your home with funds from a HELOC is a good idea if done right.
Make sure you do your homework and make certain the improvements will increase the value.
If the upgrades better your energy savings, you may qualify for certain tax credits or deductions.
If the work you want to be done on your home is costly and adds little value, then it is probably not a good idea.
Even though installing an indoor slide is pretty baller, it’s not financially smart.
Life can be full of surprises, and some of them are unwanted. If you lack an emergency fund, you may consider using a HELOC for emergencies while you build your savings.
Use it only for emergencies if that is the true purpose of the loan. Having a large line of credit can tempt you to use the funds for unnecessary things.
Purchasing Real Estate
Using a HELOC to buy a rental property or a second home could be a good idea. You’ll need to be very cautious and understand what you’re getting into.
Buying another property with funds that are borrowed against your home involves a lot of risks.
If you purchase a rental property and the tenant doesn’t make payments, you’re still liable.
Remember, the housing market fluctuates, and you risk the possibility of becoming upside down in the loan.
The Worst Uses for a HELOC
The worst use for a home equity loan is using it for anything that’s unnecessary and will ultimately increase your debt.
If you can’t buy it with your income and savings, you can’t afford it.
Getting a HELOC to buy something you can’t afford can put you in a dire financial state.
A home equity loan shouldn’t be used to invest in the stock market. Some argue that because the returns are higher than the interest rate, you should do it.
But stock market returns are not guaranteed, and you should be able to invest for the long term.
If you need to pull money out of the market to make a payment, you’re missing out on potential gains.
You could also be forced to take a loss, or even worse, not have enough to pay back the HELOC.
Borrowing against the equity in your home should be done with great caution.
Make sure you take your time and do plenty of research. Speak with multiple banks and get a second opinion.
If you have a mortgage on your home already, the HELOC becomes a second mortgage. And for most people, the financial obligation and stress of one mortgage is more than enough.