What is a Home Equity Line Of Credit? Short answer – it’s a debt trap that’s best avoided.
At its heart, a HELOC is a debt product that banks offer to homeowners which permits the homeowner to go into debt by spending the equity in their home without selling it first.
For example, if you have $200,000 worth of equity in your home, you can get a HELOC for an amount up to $200,000 depending on the lender. Without a HELOC, you would have to sell your home to get your hands on the equity. In other words, someone would give you money in exchange for your house and you could then spend that money however you wanted. There would be no fees or interest payable on that money because it would be yours.
The HELOC is a completely different beast. With a HELOC, you get access to the equity in your home via a loan from the bank without first having to sell your home. This sounds like a good thing, but it’s a debt-trap that you would be wise to avoid.
Banks charge interest on outstanding HELOC balances
You must keep in mind that the banks will charge you interest if you use a HELOC. Again, you’re spending your equity via a loan from the bank. Any bank loan is accompanied by an interest payment. Interest accrues until such time as the HELOC balance is repaid in full and it runs from the moment that you use it.
The interest rate on a HELOC is usually lower than the interest rate charged on a regular Line Of Credit. A regular LOC is an unsecured product, whereas your home secures the HELOC. If you don’t pay back your LOC, the bank cannot initiate foreclosure proceedings and take your home away from you. This is why they charge you a higher interest rate on a LOC.
Banks can foreclose on you if you don’t repay your HELOC
Before extending you a HELOC, the bank puts a charge on the title to your home. This charge against your title is similar to a mortgage. It ensures that if you ever sell your home, the bank’s HELOC will be repaid from the proceeds of the sale. You’ll get whatever’s leftover after the mortgage debt and the HELOC debt have been repaid.
Again, this particular debt product is essentially a loan against your home. It allows you to spend the equity in your home however you want. No one will be watching you to ensure that you don’t spend your equity on items which will not increase your financial security.
Having a charge on your title makes you vulnerable. Should you fail to make your monthly payment on the outstanding HELOC balance, the bank has the right to foreclose on your home to get its money back. Also, the bank has the right to demand full repayment on an outstanding HELOC balance whenever it wants. If you can’t repay the balance when asked, the bank has the right to foreclose on your home to get its money back.
Let’s say that your housing market goes down and the amount of equity in your home drops simultaneously. You house used to be worth $350,000 but now it’s only worth $250,000. Effectively , you’ve lost $100,000 worth of equity in your home. The bank may get nervous because their loan to you, in the form of the HELOC, is no longer backed by an asset that can fully repay the outstanding balance. The bank may decide to cut its losses, which means that they will demand full repayment of the outstanding loan balance. Should you not repay that balance, then the bank can proceed to foreclosure in order to get its money back before all of the equity in your home disappears due to market conditions.
HELOCs facilitate the siphoning of your home equity in dribs and drabs
When you use a HELOC, you are spending the equity in your home instead of increasing it. You are increasing the debt owed on your home each time you spend its equity.
One of the most dangerous ways to use a HELOC is to have it attached to your debit card. There is nothing stopping you from spending your home’s equity on mundane items. Think of trips to the coffeeshop, to purchase concert / sports tickets, to buy clothes, to finance your daily life. If you need a HELOC to survive from on paycheque to the next, then you’re living above your means. You’re working your way into a severe debt trap. Figure out how to free yourself and stop digging a bigger debt hole.
If there is ever a good use for a HELOC, it’s to make major repairs to your home that are required for your safety, i.e. replacing the furnace or the roof.
There is nothing wrong with you spending your home equity on the costs of your daily life if you need to. Just don’t do it via a HELOC! The wiser course of action is to sell your house and get the cash. That way, the entire amount of your home’s equity is available for your life’s expenses. You won’t be paying interest and fees to the bank for the privilege of spending your own money. You won’t run the risk of foreclosure. You won’t be indebted to the bank. And the money is still yours to spend as you wish.