'HELOC Creep' Means You're Going to Waste Your Great Home Equity

NEW YORK (MainStreet) — For want of an official term, call it "HELOC creep."

That's when a homeowner takes out a home equity line of credit for one purpose, then uses it for something else.

It's not necessarily a bad thing — not if the new purpose is really justified. But the practice can also mean that discipline flies out the window when a nice pile of cash is sitting around. On a psychological level, the decision to borrow may be more carefully considered than the decision to spend — a possibility worth keeping in mind whenever you decide to take on more debt.

HELOC creep is revealed in a study by TD Bank, which queried 1,350 homeowners on their HELOC use. Though the bank doesn't use the term, it's findings show "HELOC creep" in action.

Of those surveyed, 27% used the loan to buy a new car, though only 21% said that had been their intent when they took out the loan. HELOCs were used for emergencies by 24%, though just 19% had intended to. And 18% used the funds for health care, while just 14% had planned it that way.

While these gaps are not enormous, they do raise a question about borrowers' judgment. What, exactly, do they consider to be an emergency? Is the new car really a necessity, or is the HELOC used to buy a more expensive vehicle than needed?

To be fair, some difference between the borrower's initial intention and eventual spending is due to the nature of home equity lines of credit. Unlike a mortgage or home equity installment loan, which come as lump sum, the HELOC operates something like a credit card, allowing homeowners to borrow only what they want when they want, up to the credit limit. Over time, the borrower's needs may change.

And a HELOC can be a wise choice. Because it is a secured loan backed by the borrower's equity in a home, the interest rate can be attractive indeed. Many start in the low single digits and remain in the single digits even after the rate starts to float some months later. TD Bank says its best deals now start at 2.75%, compared with typical credit card rates of 13% to 15% or more.

But the HELOC borrower does face the risk of a higher rate later. These loans typically charge a "margin," or set number of percentage points, above the prime rate. Since the prime rate has been steady at 3.25% since the start of 2009, this has worked well for borrowers. But that could change any time. The prime rate was over 8% as recently as 2007.

During the initial "draw" period, when money can be borrowed, borrowers are generally required to pay only interest on the loan. But when the "repayment" period begins five or 10 years later, principal payments are required as well, calculated to bring the debt to zero over the loan's 20- or 30-year life.

Because future payment requirements are unpredictable, HELOCs are best used for short-term needs — for expenses that can be paid off fairly quickly. 

The ideal use for a HELOC is an expenditure that creates value, like a well-considered home improvement, college tuition or paying down high-interest credit card debt. A poor use is something that has no long-term value, such as a pricey vacation, a night on the town or an overly expensive vehicle.

It's important to shop around, as loan rates and other terms vary. Before taking out a HELOC, be sure to know how your future rates will be calculated, have a clear and convincing need for the money and devise a plan for paying the loan off as quickly as possible, especially if interest rates jump.

— By Jeff Brown for MainStreet

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