Are you a homeowner with an outstanding balance on your home equity line of credit, also known as a HELOC?
If so, you’re not alone. You’re likely not alone either in not knowing all the negative features of your HELOC.
“I think of HELOCs as a useful ‘break-glass-in-case-of-emergency” source of funds,” said George Padula, the chief investment officer at Modera Wealth Management. “A HELOC is a loan and loans eventually need to get paid back. HELOCs can be beneficial; you just need to be careful and aware.”
Here’s what advisers say you should be careful about and aware of.
The interest rate is variable, meaning that the low rate you think you have may not always be there, said Padula. “The variable rates are typically tied to the prime rate and can increase at any time,” he said. “In a rising rate environment, you have to be careful with variable rate loans.”
Most HELOCs allow you to pay interest only on a monthly basis, said Padula.
But at some time, the principal needs to get repaid. “One could end up making years’ worth of payments without realizing that those payments were not being used to pay down the principal,” he said. “When the principal needs to get paid over time, the monthly payments could jump dramatically.”
Under current tax rules, Padula said interest paid in a HELOC may not always be tax-deductible. “If the money received via a HELOC was used for home improvements, then the interest could be deductible,” he said. “But interest paid, for example, to pay off a car, consolidate debts, or other purchases would not qualify for any deductions.”
Canceled, Frozen, or Reduced
One pitfall many people aren't aware of is that the bank can cancel the program, said Matt Stephens, a certified financial planner with AdvicePoint. “We always recommend our retired clients have at least six months’ worth of expenses set aside in cash for emergencies. Sometimes people push back and say they have a HELOC, so that's their ‘emergency fund.’ I remember in 2008 with housing prices dropping, banks canceled HELOCs and people no longer had access to them at the exact moment they needed them.”
Consider a Reverse Mortgage Instead
Glenn Downing, a certified financial planner with CameronDowning, makes the case for some older adults using a reverse mortgage instead of a HELOC. “The thing about HELOCs is that, like any other loan, they must be repaid,” he said. “Even with an interest-only loan, taking out a HELOC creates a new cash outflow each month. And, as we saw in 2008-2009, banks can and do freeze these loans.”
So, if someone in retirement years is having cash flow issues, taking out a HELOC is setting one on a “collision course,” he said. “There may be equity enough to meet the cash shortfall for a period of time, but once it has been used up, the borrower is in an even worse position than before the loan.”
A great alternative is a reverse mortgage, said Downing and others.
Home Equity Conversion Mortgage
A home equity conversion mortgage (HECM) reverse mortgage is insured by the FHA and cannot be arbitrarily altered by the lender, according to Shelley Giordano, the founder of the Academy for Home Equity in Financial Planning at the University of Illinois at Urbana-Champaign.
In fact, she said the HECM grows in borrowing power every single month. “Regardless of dropping property values, the homeowner has full access to the HECM Line of Credit,” she said. “Admittedly, a HELOC will cost less to set up, but does not come with the consumer safeguards and borrowing assurances provided by the FHA Home Equity Conversion Line of Credit."