What Are the Disadvantages of a Home Equity Line of Credit?

October 27, 2020

A home equity line of credit (HELOC) can be a convenient way to borrow money. It can be much be less expensive than a credit card installment plan or personal loan. Also, with a HELOC, you pay interest only the amount of the line you use. Nevertheless, a HELOC also has some drawbacks you need to be aware of.

HELOC interest-only payments could come back to bite you

During your draw period, which can last up to 10 years, you may be allowed to make interest-only payments on the amount you borrow. However, when this period expires, you will be responsible for paying principal and interest, in addition to a possible balloon payment at the end of the loan term. You will need to prepare for these expected increases. 

Flexibility is no substitute for uncertainty

HELOCs are usually offered with only a variable interest rate. Typically, variable rate loans tend to have lower interest rates than fixed versions, but if interest rates were to rise, planning and budgeting could be more difficult.

The credit line could change

If your credit score or the value of your home declines, your lender could reduce the amount of your credit line or freeze your HELOC. Having the rug pulled from under you could upset your financial plans.

The reverse mortgage line of credit alternative

If you are 62 or older and don’t like the idea that your line of credit can be frozen, you might consider taking out a reverse mortgage line of credit. Not only can your line of credit never be frozen, but it also contains a growth feature — meaning if you don’t use it, the line will continue to grow over that period.

For those who comply with the terms of the loan, a reverse mortgage line of credit doesn’t have to be paid back until you actually leave the home, usually as the result of selling or moving out of the home or your passing away. As with other types of mortgages, loan terms include maintaining your home as well as keeping up with your property taxes and homeowners insurance.

If you like the idea of having ready access to a line of credit, ask a home equity professional to provide you a comprehensive comparison of a HELOC and reverse mortgage line of credit options.

What are the disadvantages of a home equity line of credit?

As with any other type of mortgage, your home serves as collateral for the loan. This means that if you fail to comply with the terms of your loan, your loan could default, which could lead to foreclosure. You should also be prepared for the required payment of your loan to increase from interest-only payments to interest-plus-principal payments after your draw period ends. Many HELOCs may also include a balloon payment to pay off the loan.

What is the difference between a secured and unsecured loan?

To obtain a secured loan like a home equity line of credit or a HECM, you would have to put up your home as collateral for the debt. If you fall behind on your monthly mortgage payments, per your loan agreement, you could lose your home. An unsecured loan requires no collateral. If you default, the lender can’t automatically take your property. Generally, lenders charge a higher rate of interest for unsecured loans.

What are some key differences between a home equity line of credit and a reverse mortgage line of credit?

To obtain a reverse mortgage line of credit, you must be at least 62. Unlike a home equity line of credit, a reverse mortgage line of credit can never be frozen or reduced, even if your credit or home value drops. A reverse mortgage line of credit also contains a growth feature, while a home equity line of credit generally does not. But the biggest difference is how you pay the two loans back. A home equity line of credit usually requires the repayment of interest during the draw period, which can last up to 10 years, before monthly payments of principal and interest are required until the loan is repaid. You can wait to repay a reverse mortgage until you leave the home. Of course, borrower(s) must continue to pay property taxes and homeowner’s insurance, maintain the home, and otherwise comply with the loan terms.

We hope this article has given you some help with things to think about. Of course, every situation is different. This information is intended to be general and educational in nature and should not be construed as financial advice.

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