Should I have a Home Equity Line of Credit?

Around middle Tennessee, it’s no secret that the housing market is on a tear. For about the past decade, home prices in this area continue to climb to new records. Large corporations are bringing headquarters to our state and families from high-tax states are coming to Tennessee seeking its generous income tax policies. With all the rising home prices, many are wondering how to tap into all the equity that’s being created in their home. One of the most popular ways to access the equity in your home is through a Home Equity Line of Credit (HELOC for short). Let’s explore some of the pros and cons of obtaining a HELOC.

But first, an explanation on what exactly a HELOC is. For an example, let’s say your home is valued at $500,000 and you still owe $300,000 on that mortgage. So, there’s $200,000 of equity you have in your home. This means you have 40% equity in your home ($200,000 divided by its value of $500,000). A HELOC is essentially opening a line of credit on the $200,000 you have in equity on the house. Some banks will allow you to have a HELOC up to 100% of your home’s value, but others may only do 85% to make sure you don’t borrow against all your home’s value. Even though it seems like a limitation, this can be a protective measure to help make sure you don’t end up owing more than what your home is worth.

Pros of HELOCs:

• Interest only payments only on the amount your draw. A lot of times, HELOC payments are interest-only. Meaning, your monthly payments are paying down the principal of what you borrow like normal loans. Even if you borrow a substantial amount of money, the interest portion is minimal in a low interest rate environment. The interest charge isn’t on the total line of credit available, but only on what’s been borrowed.
• Flexibility of tapping into your home’s equity in an emergency or only when needed. While this doesn’t substitute the value of an emergency fund and some cash in a savings account, it provides value by having another place to tap into if things get tight. Having a HELOC open provides near instant access to cash.
• Ability to tap into what was otherwise static and inaccessible capital. A HELOC creates liquidity out of what was once an illiquid asset (real estate).
• Usually, no costs or fees for keeping it open. A lot of banks have zero costs for opening a home equity line of credit and no fees for keeping it open throughout the year. Not all banks are the same, so be sure to read the fine print before opening one.

Cons of HELOCs:

• Rising interest rate environment can increase your cost of borrowing. Most HELOCs are based on a variable interest rate. So, when interest rates are extremely low as they have been in recent years, the cost of borrowing is minimal. However, if interest rates start to rise, that means your interest rate on your HELOC will rise, thus increasing your monthly payments and increasing your overall cost.
• Risk of overspending and increasing monthly payment obligations. Once a HELOC is opened, you immediately have access to that entire line of credit (just like a credit card). Does that mean you should spend it all? Absolutely not! But, just as some have experienced, just having the availability of credit can lead to dangerous spending habits. Be careful how much debt you’re carrying.
• Decrease in home value could have you upside down in your biggest asset. We’re so used to home values increasing, it’s hard to remember a time when home values were decreasing. But it wasn’t even 15 years ago when the entire United States housing market collapsed. If you have a mortgage and a maxed out HELOC and then your home begins to lose value, you could find yourself owing more than what your house is worth. That’s a dangerous pace to be in!

One of the most common uses of HELOCs is for home renovations or to purchase another piece of real estate. Out of all the uses of a HELOC, either of these would be considered reasonable since the funds would be used to pay and invest in assets that typically increase in value over time (personal residence, investment property, any real estate). If you find yourself tapping into a HELOC to cover day-to-day expenses, be careful and make sure you have a plan for paying back the loan balance.

A home equity line of credit is a form of debt, so always be aware of what you’re going to use the proceeds for.

Raymond James Financial Services, Inc. does not provide advice on mortgages.  Any opinions are those of the author and not necessarily those of Raymond James.