What Are the Dangers of a Home Equity Line of Credit Loan?
By David Ingram Updated November 10, 2018
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A home equity line of credit is a long-term credit arrangement that uses home value as collateral. You use the home equity line as you would a credit card, but typically for home-related issues such as home maintenance or improvement. Home equity lines of credit generally offer large amounts of credit at low monthly payments over a long period, called the draw period. This credit arrangement can be advantageous if used correctly, but you should become familiar with the dangers associated with a home equity line of credit before taking one out.
A HELOC usually carries an adjustable interest rate that may rise over time. By the loan repayment period, your monthly payment may be more than you can afford.
Know Interest Rate Risks
Home equity lines of credit feature variable interest rates that move up and down in tandem with the prime rate – the rate at which banks lend money to each other and their most creditworthy borrowers. Variable rates are generally expressed as the prime rate plus a set amount of percentage points. The danger of variable interest rates is the possibility that rates will rise in the future. Consider, for example, if you were to take out a home equity line of credit at a variable rate, initially set at 7 percent, when fixed rate consumer credit arrangements are currently offered at 8 percent. If the variable rate increases to, say, 11 percent in four years, you could find yourself paying significantly more in interest than if you had taken the fixed rate loan.
It's Easy to Overspend
Home equity lines of credit are easy to use, though they may not be easy to obtain. Since monthly payments are low and credit levels are high, consumers can quickly find themselves with buyers' remorse and a large amount of debt. As with credit cards, it can be easy to get out of control while justifying current purchases with future income expectations, which may not always turn out as planned.
You Must Repay
Although monthly payments are relatively low and payment term lengths are generally long, home equity lines of credit must be paid in full at the end of the draw period. This may not be a problem for borrowers who have made consistent monthly payments, but it can present a significant challenge to individuals on a temporarily tight budget. The danger inherent in the immediate repayment terms of home equity lines of credit is the risk that you may not be able to pay when the draw period ends, forcing you to obtain a loan from a secondary source.
There's High Risk of Default
If you can't pay off your home equity line of credit when it becomes due, you can try to obtain a second loan to pay off your home equity line of credit balance at the end of the draw period. But if you can't get a second loan and you can't pay back your home equity line of credit, you could lose your home. Aside from your taking a hit to your credit score and potentially seeking bankruptcy, the bank may choose to foreclose, leaving you looking for a new place to live.
The Motley Fool: Home Equity 101
Investopedia: How a home equity line of credit (HELOC) can hurt you
Lending Tree: The Pros and Cons of a Home Equity Loan?
David Ingram has written for multiple publications since 2009, including "The Houston Chronicle" and online at Business.com. As a small-business owner, Ingram regularly confronts modern issues in management, marketing, finance and business law. He has earned a Bachelor of Arts in management from Walsh University.
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