September 22, 2022
The sharp rise in home values over the past few years has been a boon for homeowners. And as home equity values have increased, so too has the demand to take out home equity lines of credit (HELOCs).
As a general rule, lenders allow qualified homeowners to take out a HELOC, or home equity loan, as long as they have at least 20% equity. A recent analysis by Black Knight estimates there is now $11.5 trillion—yes trillion—in tappable home equity.
TransUnion reports that the number of HELOC accounts grew 40% last year. I expect that trend is continuing this year, as rising mortgage rates make it less advantageous to do a cash-out refinance.
If you are considering tapping some home equity, you better be smart, and smart means careful. Here are the HELOC risks I want you to understand before you take out a HELOC.
You are putting your home (more) at risk.
You know that if you fail to keep up with your mortgage payments, your lender could foreclose on the property. Well, a HELOC works pretty much the same. Your home is the collateral. If you don’t follow the repayment rules you could face the same risk.
The draw period can be dangerous.
The way HELOCs work is that during the initial draw period, you can tap your line of credit whenever you want. The typical draw is 10 years. And if you want, all you need to repay during the draw is the interest owed when you draw on your credit line. That can make it seem like it’s incredibly affordable to borrow from your home equity.
But after year 10, you switch into the repayment phase. You can no longer borrow more from your HELOC, and you must repay the outstanding balance of what you have borrowed. The typical repayment phase is 20 years. Not 30, but 20. You better have a plan for paying that back.
Your home is not a piggy bank for wants.
Given your home is at risk, I don’t want you opening a home equity line of credit and then using it for non-essential spending such as vacations. Nor should it be used to buy a car. And I really don’t like the idea of using home equity to pay for a child’s college, if that means you can’t keep up with saving for retirement because you are repaying the HELOC. The better move is for your child to attend a school that requires less out-of-pocket spending for them, and you.
Nor should it be used to overspend on home improvements. A sign you are potentially overspending is if you think you will need many years—not just many months—to pay for a renovation project.
The interest rate may rise.
Many HELOC loans have an adjustable rate, meaning the interest payment can fluctuate based on what is going on with interest rates in general. If you expect to need years to pay back money from a HELOC you might want to consider looking for a fixed-rate HELOC, to protect yourself from the risk of rising interest rates while you are repaying the loan.
Your line can be cut off at any time.
A HELOC should never ever be used as a standby emergency fund. During the financial crisis, many HELOC lenders froze borrowing from a HELOC or reduced the size of the credit line. They did that because the collateral for HELOCs—home values—were falling sharply. Hopefully, we won’t see a replay of what happened to the housing market in the financial crisis, but you never know. Please don’t bank on a HELOC as an emergency fund.