The trouble with HELOCs

All of a sudden everyone is excited about Home Equity Lines of Credit again. Offers are coming at us in print, on TV and electronically. "Use your home's equity!" they scream. Do you remember what trouble we got into the last time we all took HELOCs? Let me remind you.

When you have great terms on your first mortgage, it might be tempting to take out equity as a second mortgage, and leave the first alone. Often this is done as a HELOC. You usually get a low interest "teaser" rate for a few months, then the interest rate begins to adjust. You repay monthly interest on what you have borrowed, so the payments are low – but that also means you are not decreasing the principal balance. Most HELOCs have a draw period, say 10 years, when you can borrow from the line when you need the money. At the end of the draw period, you repay the outstanding balance in fully-amortizing payments, but the interest rate keeps adjusting.

Here's an example from a local credit union. That's usually the place you'll get the best terms. Say your home is currently worth $400,000, and you owe $250,000 on your first mortgage. If you borrow up to 80% of the value, you could get a HELOC for $70,000. ($400,000 x 80% - $250,000).

If you borrow $40,000 against the line, at the introductory 3.99% rate, your interest-only payments are around $133/month. At the end of 12 months, you would still owe $40,000, and now the rate begins to change monthly. For a great borrower, that might mean using the Prime Rate plus 2%. Today that equals 7.25% - who knows what it will be in the future. Anyway, in our example the interest-only payments become $250/month. And if you borrow more against the line, the figures get bigger.

But even that is not what concerns me. Think ahead several years, when you are tired of a rate that keeps increasing, and payments that keep increasing, and you want out of that HELOC. Will you have the equity to combine your first and second into a new loan?

When you put two loans together, it's considered a "cash out" mortgage. Equity thresholds are lower for this type of loan. In the last go-round, many of us got caught with not enough property value to do this kind of transaction, or were otherwise unable to qualify, so we were stuck with high second mortgage payments. And banks began closing our lines of credit with no notice. It was a tense time for lots of people.

Please get thorough information if you are considering taking a Home Equity Line of Credit. Play out the entire lifetime of the loan, and be sure you know what the actual repayment terms look like. There might be other alternatives to doing it, so ask and ask and ask. Let's not put our homes on the line like we did last time.

Tammy Engel is your local Mortgage Advisor. She's been working for your best interest since 1990. Contact her at 661/822-7325 for purchase, refinance, and reverse mortgage. NMLS #235051 CaDRE#01273839