Our homes are our greatest asset, and in times of cash crunch, they could provide much-needed relief. A home equity line of credit, also called a HELOC, can put money in your pocket.
A HELOC is a second mortgage that allows you to borrow against the equity in your home up to a certain amount, based on the value of the home and the amount you still owe on the primary mortgage.
A variety of lenders issue lines of credit, and each bank has different criteria, fees and repayment options. Here are some basic facts about these loans to help you decide if a HELOC is a good idea.
Reasons to Take Out a Home Equity Line of Credit
The main purpose of a HELOC is to use the money to increase the value of your home.
“Ideally you should use it to remodel your home, so it’s the ability to go in and buy a home, borrow against that home, remodel it and make it yours,” says Mary Bell Carlson, a CFP and AFC known as the Head of financial parent. “Now they get used to everything under the sun.”
Carlson says many people use HELOCs to pay off high-interest credit card debt. The rates on most equity lines are much lower than on most credit cards after introductory offers. But it’s important to keep in mind that over the life of the loans, rates on HELOCs adjust often and can increase.
But she has a warning: “If you take money out of your home equity and borrow it for any reason – whether it’s to actually renovate your house or to pay off credit card debt or for an emergency fund in times of crisis – you are now taking on unsecured debt and securing it now.”
This means that if you don’t pay, your house is at risk of going bankrupt.
“If you don’t pay your equity lender, they can absolutely come and take your house,” she said. “There are actually teeth in their bite, whereas with (collection agencies) they are just annoying.”
Obtain a home equity line of credit
Even with the risk, a loan with a lower interest rate compared to the equity in your home can be a way to get through a financial crisis.
The amount you can borrow depends on the current value of your home, how much you owe on your current mortgage, your mortgage debt to income ratioyour credit score and other criteria depending on the lender.
But just because you paid for a mortgage doesn’t necessarily mean you’ve built up equity. Home equity is the difference between what your home is worth and what you owe. It builds up over time as you pay off your mortgage.
“If you’re someone who has zero, 1% or 2% invested and recently bought your house, you don’t have the ability to borrow for that,” Carlson says. An interest-only loan can also mean a lack of equity because you haven’t paid off the principal, just the interest, she added.
Is a HELOC a good idea?
Carlson has some advice for those wondering whether a HELOC is a good idea.
- Consider the fees and costs: Most likely you will need an appraisal to determine the current value of your home, and you may also need a title search. These cost money, and there are also additional costs that banks charge.
- Shop around: You do not have to use the company that has your first mortgage for the HELOC. Different banks offer different rates, so do your homework and find the best one.
- Know your debt-to-income ratio: Take a look at your net income and make sure you have enough money to pay off the mortgage and leave enough for living expenses.
- Lifespan: Consider how long you plan to live in your home. The money from a HELOC must be paid back before the home is sold, so if you plan to move in the near future, it may not make sense to borrow against the equity.
“Home equity lines of credit can be a very low-cost borrowing alternative if necessary,” says Carlson. “So if you don’t have a savings or reserve fund and are in need during this economic downturn and crisis, this may be a suitable lending technique.”
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