Home equity loans are on the rise with interest rates convincing more homeowners to stay put, and studies predict this trend isn’t about slow down anytime soon.
But if a homeowner is considering using some of their equity, how do they decide between a line of credit and a cash-out refinance – what’s good? What’s better? What’s best?
While the answer may depend on a person’s particular situation, one rule applies to all: Whatever you do, make sure you do it securely, efficiently and have a financial plan that exceeds the term of the loan you choose.
When weighing your options, there are some significant variables to consider. First, HELOC access can change at the drop of a hat, subject to changes with the bank, the market or the borrower.
I don’t know about you, but once I have access to my equity, I don’t want someone else to be able to alter our agreement when they decide it benefits them. The bank wouldn’t let me change my side of our agreement if I wanted to.
Many different circumstances can change access to your equity through a HELOC, and many of these factors are out of your control. The bank’s ongoing assessment of the property’s value, their ongoing assessment of the interest rate markets, or even their ongoing assessment of you as a borrower can all lead to your equity access being reduced or completely removed.
Imagine a bank calling your HELOC due because the interest it is earning is far lower than the current market would be yielding them. That can’t happen…right? Wrong. It can absolutely happen. (Make sure to read the “demand” features before you buy.)
Second, HELOC defaults are (likely) taxed. Defaulting on your home would be horrible, and having to pay taxes on that defaulted amount would make it that much worse. But that is exactly what will happen on any defaulted HELOC or home equity loan balance that you cannot prove was used to specifically improve the home you borrowed it from.
Although many homeowners are smart enough to recognize their home equity as a tool to help consolidate debt, invest in their future, or get money for the down payment on a new home, they would be wise to consider the worst-case scenario for the terms of the debt they are deciding to use.
Third, HELOC interest rates are almost always adjustable. This means each and every time the prime interest rate changes, the amount of interest you will be forced to pay can and will change too. Wait, but that can be a good thing if rates fall, right? Sure! But do you think rates are getting ready to fall soon?
Most HELOCs start with a low teaser rate (even below prime in some cases) but adjust quickly thereafter. More than likely, consider that the prime interest rate market changes for the worst and the rate you are paying climbs rapidly. This is precisely what has occurred over the last several years, and what will likely continue to occur for many more.
Even with a sag in the rate market loosely predicted sometime in “the future,” they are not predicted to fall below the still historically low average rates today. The ultimate financial value of debt is fixing the cost of money into the future. If you do not fix the amount of interest you could pay today, you will pay more tomorrow.
Fourth, HELOC payments are usually interest only. Most borrowers choose the interest-only option because it is the smallest monthly payment available. But with no plan or ability to repay these large HELOC debts, many people end up servicing interest-only HELOC debt just like they service their credit card.
I mean, I too use credit cards from time to time, and there are even some months that I choose not to pay them off, which costs me a little interest. But could you imagine having a $50,000 credit card maxed out? How about a $100,000-$200,000 credit card hitting its max? This is exactly what the average HELOC user does and what most would have to do with a large principle balance – service the debt until they have a better option.
At this point, you may be thinking that I am not a big fan of HELOCs, but you would be wrong.
I love HELOCs, actually!
They provide a borrower with another way to access more of what belongs to them.
And I think you should be able to access all of your value, not just some of it. I think what you are going to do with the equity and the different terms for the loan that allows you access to it, ultimately should determine your opinion on which debt is best far more than the monthly payment alone.
I think most people choose HELOC or cash-out refinance based on the short term, the lowest payment, the easiest process or the cheapest cost. Some HELOCs will allow you access to 100% of the value of your home! That’s awesome. A cash-out refinance will generally allow access of up to 80% loan-to-value without private mortgage insurance (significant). Sometimes a cash-out might even allow you to borrow up to 85% LTV at a higher cost if you add PMI.
Why not have an 80% first mortgage (the most efficient and safe) with another 20% of the home’s value available in a reserve HELOC? I mean, unless you think having access to 100% of what is yours is a bad thing?
I think it is safer to use 30-year fixed-rate loan to cash out up to 80% while rates are low and open a HELOC up to 100% CLTV for more of an emergency reserve fund, or temporary-use fund after.
When you get all that equity, do yourself a favor and create a compounding liquid reserve with years of payments in waiting, because things will change. Your income could go up, you could lose a job, or you could be faced with a life-changing medical event. If and when those things occur, a reserve will allow you time to make the best decision possible and avoid default.
Ultimately, even if you disagree here and take out a large HELOC, I have seen what happens on the back end of high-balance HELOC debt. It gets paid off with the sale of the property, consolidated into a first mortgage, and even sometimes paid-off with large unexpected earnings.
Whatever happens, make sure you know how you are going to pay it off. If the most likely way you will get rid of a high-balance HELOC is a consolidation into a first mortgage, why not do it while the interest rates are better?