HELOC - Great idea, but possibly dangerous

Home equity line of credit, or HELOC, comes with some dangers

One popular type of loan these days is the HELOC, or home equity line of credit. We’ve outlined it in detail elsewhere, but in essence, it’s a renewable loan against your home. The duration is set, the amount is set, and during the time of the loan, you may borrow and repay, and borrow and repay. It’s a great type of loan for that indefinite home remodeling project, or perhaps graduate school. In fact, a HELOC has many uses.

There are problems with a HELOC, and anyone considering such a loan should be aware of them, as it is easy to get into problem debt with such a loan, and by signing the loan documents, you are putting your house at risk.

Here are a few things you need to know:

Interest rates are currently quite favorable, and your HELOC comes with variable rates. That means that if you take out a HELOC to remodel your kitchen and decide to take several years to pay it off, you may see your interest rate, and payments increase dramatically. There’s no telling what the interest rates may do in the future, but the rates now, which have just started rising, are near historic lows. In other words, the rates are sure to go up, and with them will go your payments.

Watch out for fees. Most home equity lines of credit now include fees for early termination. If you close your account before a specified date, you may find yourself paying hundreds or thousands of dollars in fees. Read the fine print on this one, or you could end up paying a lot of money unnecessarily. Also be aware that many, if not most, lines of credit require actual use or you may incur an inactivity fee.

Don’t assume that your equity will increase. With home prices rising steadily throughout the country, many borrowers just assume that they can take out a home equity loan and pay it off by selling the house later. In other words, they don’t give much thought to how they’ll eventually pay off the loan. The problem here is that home prices may soon fall, particularly as the long-term effects of Hurricane Katrina become felt throughout the industry. Should your home value fall and you find yourself needing to sell, you may discover that you don’t have enough equity to retire the loan. If that’s the case, you’ll have a healthy bill on your hands.

Don’t spend on frivolous items. We’ve covered this before, but spending your home’s equity on luxury cars or vacations isn’t a good idea. The best uses for home equity borrowing are improvements in the home itself, which adds to your equity, or education, which adds to your earning power. Other options are more risky, and you’ll end up paying for that vacation, at high interest, for years to come.

A home equity line of credit is a great way to borrow money, offering tax benefits and relative ease in terms of paperwork. They can be dangerous, and anyone borrowing money for one should realize the risks.