A home equity line of credit, commonly abbreviated as HELOC, is a special debt instrument that combines financial elements of a mortgage loan and a credit card, HELOCs are subordinated mortgage obligations that allow homeowners to borrow against the equity of their properties. The current lending guidelines allow borrowers to take out HELOCs up to 85 percent of the property value.
The difference between a HELOC and a second mortgage is that the latter converts the equity into a check while the former is granted as revolving debt. With a HELOC, borrowers do not have to use up the entire amount; they can take out the money they need and start paying it back just like a credit card. Unlike credit cards, however, HELOCs are secured loans.
Benefits of HELOCs
Traditionally, HELOCs are used to pay for home improvement projects or as a source of cash in case of emergencies. When homeowners use HELOCs to pay for remodeling projects, they are essentially borrowing from their equity to boost their equity.
Compared to credit cards, HELOCs are more attractive due to their lower interest rates and their repayment options. Since they are essentially second mortgages, the interest paid can be deducted when you file your annual tax return.
Since the 1990s, HELOCs have become popular vehicles for consolidating credit card debt. This is similar to taking out a loan to pay off outstanding credit card balances; however, the terms are more attractive due to the lower interest rates and the chance that the property value will continue to appreciate. HELOCs make it easy to pay off credit card debt faster and more efficiently.
Considerations When Taking Out HELOCs
There are three factors homeowners should consider when using HELOCs to consolidate credit card debt:
HELOCs require a fair amount of financial discipline. First of all, they are mortgage products that put a lien on the property. Failure to pay the HELOC on time could result in foreclosure.
Taking out a HELOC means paying for another mortgage loan, which means having to pay origination fees. For the most part, HELOCs are not as expensive as first mortgages; however, they require appraisals, underwriting and processing that must be paid by the borrower. Before applying for a HELOC and using it to consolidate credit card debt, homeowners should calculate the borrowing costs and whether they make sense in the long run.
There is always a risk that the value of the property may stop appreciating or even dropping when the real estate market decelerates. Tying up home equity with a HELOC could result in an upside down or underwater situation for homeowners who owe more than what their homes are actually worth.
HELOCs are usually adjustable rate mortgages. Should economic conditions suddenly shift, borrowers may end up paying more than what they planned. This is not an ideal situation for homeowners who are on a budget.
In the end, while HELOCs can certainly be used to pay off high credit card debt, homeowners should not rush into tapping the equity of their properties without evaluating the costs and potential risks.