Home Equity Lines of Credit (HELOC) provide homeowners with a ready source funds for major planned and unplanned purchases. A HELOC works much like a credit card, providing a secured cash advance whenever the homeowner needs to make a purchase. Typically, the HELOC does not restrict a borrower’s purchases, but the deductibility of the interest on the loan may vary.
HELOCs hold several advantages and disadvantages. On the positive side, a HELOC can make a substantial amount of credit available to a homeowner. The amount of available credit will vary between borrowers and is determined by factors like the value of the borrower's home, the remaining balance on the original mortgage, the existence of a second mortgage or other liens on the property, the borrower's credit history and current debt load.
Borrowers may be able to deduct HELOC-funded purchases, depending upon how the HELOC funds are used and how much money is involved. The Internal Revenue Service has established limits on the deductibility of HELOC funds. Publication 936 - Home Mortgage Interest Deduction – explains these limits in detail.
With HELOCs, borrowers can usually borrow up to the full amount of the credit limit whenever they need to. HELOC purchases are typically not restricted, but HELOC loans usually contain provisions that allow the lender to freeze or reduce the available credit under certain circumstances. HELOCs also may contain minimum withdrawal provisions that require a certain level of expenditure for each transaction.
Some lenders will convert HELOCs from a variable interest rate loan to a fixed-rate loan. Other lenders will convert a portion of the credit line to a fixed-rate loan. A borrower can limit his exposure to risk and stabilize his monthly payment with this kind of conversion.
Because the borrower's home secures a HELOC, the interest rate is often lower with a HELOC than it would be with a traditional second mortgage. Some borrowers may find the lower interest rate to be an attractive feature of HELOCs.
While HELOCs offer many positive features, they also contain drawbacks that any potential borrower should be aware of. First and foremost, a borrower secures a HELOC with the equity in his home. As with a conventional mortgage, the borrower risks the loss of his home if he fails to meet the terms of the loan agreement.
Another drawback of HELOC loans is that the borrower's payments may only cover the interest on the loan or may only cover a portion of the principal owed. The borrower's payments may not reduce the principal amount owed at all, or may not reduce it enough to pay off the loan in full over the term of the agreement. The borrower may then be required to pay off the outstanding balance of the loan immediately when the term of the loan expires.
The interest rate on a HELOC is variable, and the monthly payment may change periodically as a result. If interest rates increase substantially, a borrower's monthly payment will also increase, sometimes beyond the borrower's ability to pay. Usually, HELOCs contain provisions that limit the amount of increase for the loan's interest rate, or that limit the increase of the monthly payment. Monthly payment limits may cause problems for borrowers at the end of the loan period, if the amount of the payments over time has not been enough to cover the principal owed.
HELOCs may contain a built-in “balloon payment" at the end of the loan. A balloon payment is a large sum of money that is due in full at the conclusion of the loan. A loan with a balloon payment typically requires the borrower to refinance the balloon amount, renew the loan, or pay the balloon amount in full.
The lender may require the borrower to pay the outstanding balance on a HELOC immediately and in full if the borrower sells the home, reducing or eliminating the borrower’s ability to purchase a new home. Further, the lender may prohibit the borrower from renting a home with a HELOC to guarantee that the borrower retains the property as his principal residence over the course of the loan.
In all, borrowers should understand HELOC loan terms before they enter into such agreements with a lender and should evaluate other options, such as second mortgages. When comparing interest rates among several loan products, potential borrowers should remember that lenders do not calculate the APRs of HELOCs and conventional loans in the same way. The APR of a HELOC does not always represent the true cost of borrowing, since it does not include the same fees that a conventional loan's APR includes.
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