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Home Equity Lines of Credit: Blessing or Curse?

A home equity line of credit, or HELOC, is a home loan that utilizes the homeowner’s equity as collateral against the loan. What does that mean, exactly? It means that the bank from which you obtain your HELOC is using the percentage of your home that you own and have paid for as a guarantee of payment in the event that you should fall on hard times and not be able to repay the loan.

A home equity line of credit is very similar to a secured credit card. It is a revolving credit line, so that means when you spend on the account, you will simply make monthly payments to increase your available credit. Unlike a mortgage or car loan, which has a large balance that you pay down over time until you no longer owe anything, a home equity line of credit can provide you with access to cash no matter how much you utilize it and then pay it off. Sounds great, right? Listen up: home equity lines of credit may not be the best possible choice for you, as they do have their downsides.

The Rates & Rules

First and foremost, interest rates on a home equity line of credit are often far less than desirable. Banks sometimes lure borrowers in with attractive sounding interest rates of 2 or 3%, but these rates often increase after the first three to six months.

For borrowers with even slightly imperfect credit histories, the HELOC may present with an even higher rate; many times 2, 3 or even 4% over the prime rate, which means that the applicable interest rate on the actual home equity line of credit could be as high as 7 or 8%. While this is certainly better than some credit cards, it’s definitely not optimal—even for those with less than perfect credit.

HELOC products are considered to be adjustable rate mortgages, or ARMs. This means that the rate of interest a borrower will pay will vary based on the federal prime rate, which is constantly changing. While it’s true that the prime rate can decrease, home equity line of credit borrowers may be taking on a big risk when they choose to tie that account to the variable prime rate. For those not looking for a bit of financial risk, a HELOC might not be the best choice in borrowing.

In some cases, HELOCs will present homeowners with relatively stable monthly minimum payments. However, depending on the way the loan is set up to amortize, homeowners may find themselves with a hefty balloon payment that may throw their monthly financial goals through a loop.

In addition, most home equity line of credit accounts have a minimum amount of cash the borrower can draw from the account at one time, so it might be necessary to borrow more money—and pay interest on—than the borrower really needs.

The Ugly

One up-side of an adjustable rate mortgage, or ARM, is that there are caps on interest rates. While ARMs do indeed take on similar risks to home equity lines of credit, an HELOC has no such cap, so there is no limit to the amount of interest that can be paid if the federal prime rate should suddenly skyrocket. While it is true that the interest rate only increases a quarter of a point at a time, that is no guarantee than over the course of years it will not increase several points or more.

Most home equity lines of credit are taken out for 25-year terms. This means that the amount of credit available in the loan will expire after 25 years, whether or not the balance is paid in full. If the borrower chooses to close the HELOC before the 25-year term is expired, they will likely be subjected to an early closure fee, which can be hundreds of dollars.

Is There a Better Choice?

Most people open home equity lines of credit is a type of additional mortgage to do things like pay off credit cards or student loans, make home improvements, send their kids to college or even just to have as a backup plan in case catastrophe strikes. While these are all valid reasons to have access to a large sum of money, there are certainly better ways to achieve these goals without taking the risks that HELOCs presents to borrowers.

A great way to achieve financial goals without taking on the risks of an adjustable rate loan product such as a home equity line of credit is to refinance the mortgage and cash out some of the equity. Not only can doing cash out refinance on a mortgage be a great way to pay off credit cards and other debts and prepare for the future, it can also be a good way to lower monthly payments as well.

Mortgage interest rates are at historical lows at present, so homeowners will find, first and foremost, that a simple decrease in interest rate will drop their monthly payments significantly. The real magic is beyond that, though. By cashing out a portion of equity, you get to achieve the ultra low interest rates you receive on your mortgage and roll those higher interest rate debts into that. The average credit card interest rate is 15%, but mortgage interest rates are much, much lower. Paying off debt in this manner can eliminate thousands of dollars interest.

If a borrower considers their mortgage term too, many also find that they can decrease the term of their mortgage loan so that they will achieve full home ownership even faster—all while getting a cash payment to use as they wish and lowering their mortgage interest rate at the same time. It’s a win-win scenario from all sides.

If you are considering opening a home equity line of credit and want to see how a cash-out refinance might be able to help you better and save you more money, call one of NLC Loans™ personal mortgage advisors today, toll-free, for a 100% free mortgage evaluation at 877-480-8050 or contact us online.