A home equity line of credit (HELOC) isn’t the best choice for every borrower. HELOC loans give borrowers the flexibility to liquidate their home equity at the drop of a hat. However, there are also some risks involved with taking out a HELOC. This article will help you determine if a home equity line of credit is right for you.

The Risks of Removing Equity from Your Home

In order to qualify for a HELOC loan, you must agree to use your home as collateral. Using your home as collateral makes it possible for lenders to give you a large credit line at a low interest rate. However, if you ever default on the loan, your home is at risk. If you do not pay back the HELOC, the lender may foreclose on the property.

One of the risks of removing equity from your home is that real estate market values fluctuate. If your home’s value declines, you may owe more money than your home is worth. For example: A homeowner purchases a home for $400,000. During a real estate boom, that property appraises at $600,000. If the owner takes out a HELOC for $200,000 (and uses the full limit), he then owes $600,000. Should the home’s value decline $100,000, the owner will owe $600,000 on a $500,000 home. He will not be able to pay off the HELOC by selling the property.

The real estate market will inevitably fluctuate. Before removing any equity from your home via a HELOC or other loan source, make sure you can pay the money back without selling your home.

HELOC Alternatives: Refinanced Mortgages and Home Equity Loans

Before you decide to apply for a HELOC, take the time to consider your alternatives. Homeowners that qualify for a home equity line of credit may also choose to liquidate their equity by refinancing their current mortgage or by taking out a home equity loan.

Refinancing will give you an entirely new first mortgage. You’ll replace your original mortgage with new terms and a new interest rate. If your home appraises for more than the amount you currently owe on your mortgage, the lender may give you the difference. Refinancing your mortgage may be a smart choice if interest rates are down and you need a lump sum of money. The downside of refinancing your mortgage is that lenders often charge a lot in fees and points (money you pay up-front to lower your interest rate). Although it is possible to refinance your mortgage to a shorter term, many borrowers refinance with a new 30-year loan. If you want to own your home outright, adding an additional 30 years to the life of the loan may not be the best choice.

Home equity loans are secondary mortgages that give borrowers an upfront sum of money for a fixed period of time (usually between 10 and 20 years). Borrowers with home equity loans generally have a fixed rate and know what their monthly bill will be ahead of time. Home equity loans are often more expensive than home refinances, but they do not require borrowers to change the terms of their original home loan. Because the interest rate monthly payment is known beforehand, home equity loans offer more peace of mind than HELOC loans. However, home equity loans do not have the same repayment flexibility as HELOCs. Borrowers with home equity loans must take a lump sum of money at one time and do not have a revolving line of credit to draw from.

HELOC loans, on the other hand, provide a revolving line of credit. Like a credit card, you can draw money from your home equity line of credit whenever you choose. If you do not draw from the line, you do not have to make a monthly payment. Borrowers can generally use their HELOC during a 5-10 year draw period. After the end of the draw period, you will have to pay back the money you’ve borrowed. Some HELOCs require borrowers to pay back the money at the end of the draw period, some provide a 10-20 year repayment period, and some offer borrowers the opportunity to renew the line of credit for an additional term. All HELOC loans start out with adjustable interest rates, tied to the prime rate (the banks that currently lend to their most credit-worthy customers). Since the rate can change from month-to-month, HELOC borrowers do not know what their monthly payments will be before receiving the bill.

Pros of HELOC Loans

HELOC loans offer a few features that can’t be found in personal loans or other second mortgages. Here are some of pros of taking out a home equity line of credit:

Lower interest rates than most credit cards and personal loans. Since HELOCs are secured by property, lenders are able to offer substantially lower interest rates. The average HELOC interest rate is 1 percent above the current prime rate – a few HELOCs even offer interest rates set at prime.

High credit limits. If your home has a lot of equity, you will probably receive a very high limit on your HELOC. You do not need to specify how you will use this money. You can use it to start a business, do home renovations, pay tuition, or anything else you please.

Tax-deductable interest. Since a HELOC is technically considered a home loan, most state and federal laws make the loan’s interest tax-deductable. Now, that’s a feature you won’t find in any credit card offer!

Revolving credit line. Unlike home equity loans and home refinancing, HELOCs do not give borrowers an upfront sum of money. Instead, you can take out cash whenever you please. When you have no money withdrawn, you pay no interest.

Low fees. Most borrowers are able to take out a HELOC without paying much (if any) money upfront. Refinancing or taking out a home equity loan could cost thousands – but, lenders commonly open HELOCs with no upfront charge.

Flexible repayment. Many HELOC lenders offer flexible repayment options. As a borrower, you may choose to make interest-only payments during some months, you may turn a HELOC withdrawal into a fixed-interest loan, or you may extend the term of the credit line. Keep in mind that not all HELOC lenders offer these features.

Cons of HELOC Loans

Not everything about a HELOC benefits the borrower. Here are a few of the cons of taking out a home equity line of credit.

Adjustable interest rate. HELOC loans start out with an adjustable interest rate tied to the prime rate. As the prime rate changes, so does your interest rate. Generally the prime rate is raised or lowered .25% at a time. If the prime rate skyrockets during any given year, be prepared to see a big change on your bill. Most HELOCs adjust their rates regularly, either monthly or quarterly.

No periodic rate caps. Most adjustable rate loans have periodic rate caps (limits on how much interest rates can go up in a set time frame, such as one year). However, it is very difficult to find a HELOC with this feature. If your HELOC does not have a periodic rate cap, your interest rate can rise quickly and unexpectedly. Fortunately, the majority of HELOCs do have lifetime caps, so your interest rate will not exceed a set percentage over the life of the loan.

Early closure fees. If you decide to close your HELOC early, you may be dinged with an early closure fee of several hundred dollars. Fortunately, many HELOCs do not have a prepayment penalty. Instead of closing the line, you can simply pay off the loan and stash your card/checks somewhere for safe keeping.

Minimum draw amounts. Many HELOCs require borrowers to draw a minimum amount of money from the credit line. You can avoid this problem by asking your lender for a HELOC that does not include a minimum draw clause.

Possibility of line freezes. Most HELOC lenders reserve the right to reduce or freeze your HELOC line should the value of your home decrease. Although this is very uncommon in booming markets, it is a possibility. Over 100,000 HELOC customers had their lines frozen with no advance warning in early 2008.

Difficulty refinancing first mortgage. In order to refinance your first mortgage, you must get approval from the HELOC lender. Usually this is no problem; but in some cases (such as a declining market) HELOC lenders refuse. In this instance, the only way to refinance your first mortgage is to payoff and cancel your HELOC or refinance your HELOC with a different lender.

Taking out a HELOC is a big decision. By carefully considering the above risks and benefits, you can make the best financial decision for your situation.

Next: How to Qualify for a HELOC

See Also: Home Equity Loan vs. Home Equity Line of Credit 

HELOC Vocabulary

Refinance – To replace the original home loan with an entirely new mortgage. The new loan can be from a new lender and have a new interest rate.

Home equity loan – Secondary mortgages that give borrowers an upfront sum of money for a fixed period of time (usually between 10 and 20 years) at a fixed interest rate.

Prime rate – The interest rate at which commercial banks currently lend to their most credit-worthy customers.

Adjustable rate – An interest rate that changes on a periodic basis.

Periodic interest rate cap – The limit on how much an interest rate can rise in a given time frame.