Online Debt Consolidation | How HELOCS Can Hurt You
December 19, 2011 – 12:35 pm
You may have heard that a home equity line of credit (HELOC) is a convenient, flexible and low-cost way to borrow money. All of these statements can be true if you manage your HELOC prudently. But if you don’t, a HELOC can become very expensive and get you into financial trouble. Here’s how.
Rising Interest Rates Can Increase Monthly Payments and Total Borrowing Costs
HELOCs generally have variable interest rates. The interest rate is based on a benchmark rate, such as the Fed funds rate, plus a margin, which is established by the lender. When interest rates go up, your monthly payment will go up.
There’s no way to predict when increases will happen or how much they will be. Your new monthly payment could be unaffordable, and getting behind on your payments can lower your credit score and increase the amount of interest you owe. The fine print of your HELOC should state a maximum possible interest rate, but if your current interest rate is 6% and the maximum is 20%, that information isn’t going to be very comforting.
Interest rates also affect your long-term total borrowing costs, not just your monthly payments. If the interest rate on your HELOC increases before you pay it off, the total cost of whatever you borrowed the money for goes up. A larger interest payment also means that you have less money for other things, such as paying bills or saving for retirement.
One way to combat the risk of rising interest rates is to establish a home equity loan, which has a fixed rate, instead of a HELOC. Another option is to take advantage of the fixed-rate option that is offered with some HELOCs.
However, in exchange for the certainty of a fixed rate, you’ll generally pay a slightly higher interest rate than you would on a variable-rate HELOC. This dynamic is similar to the one that exists between the interest rates of adjustable-rate mortgages and fixed-rate mortgages.
Fluctuating Monthly Payments Can Cause Financial Instability
Having a HELOC is similar to having an adjustable-rate mortgage in that your monthly payments can change significantly when interest rates change. It can be difficult to budget or make future financial plans when you cannot predict your monthly payments or your total borrowing costs.
Some borrowers are comfortable taking on this level of risk, especially in low interest rate environments or if they know they can afford higher payments. If you need a lower level of risk in order to sleep soundly at night, a home equity loan or fixed-rate option on a HELOC may once again prove to be a better choice.
Interest-Only Payments Can Come Back to Haunt You
Some HELOCs have an option that allows you to make interest-only payments on the money you borrow, during the first few years of the loan term. Interest-only payments seem great in the short term because they allow you to borrow a lot of money at what appears to be a low cost.
In the long run, the picture is not so rosy. Borrowers who choose interest-only payments will face dramatically higher monthly payments later on, and possibly a balloon payment at the end of the loan term. If you don’t budget for these increases, or if your financial situation stays the same
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