Explore whether a HELOC is a financial trap or a smart solution for accessing equity. Understand risks and benefits before making a decision.
Homeowners have a lot to look out for. There’s making sure that a homeowners insurance policy is up to date, keeping an eye on the housing market to see how much additional equity has been accrued in the latest spike, and questioning if this is the year the roof gets replaced any time a strong breeze rolls through. However, there are often bigger risks on the horizon—like the reverse mortgage and real estate scams that have grown in prevalence in recent years.
It makes sense, then, that many homeowners are wary of the home equity line of credit (HELOC). But is a HELOC a trap? Read on as we answer this common question before outlining some strategies to help homeowners keep their equity out of harm’s way.
First things first: What is a HELOC? A home equity line of credit is a type of loan product—often called a second mortgage—that allows homeowners to borrow against their home equity by gradually drawing from a set line of credit. Because a home equity line of credit is secured by the mortgage, this approach typically brings with it better interest rates than a personal loan or credit card.
So, where’s the trap? While it might not be completely fair to label all HELOCs traps, some homeowners do fall victim to their potentially confusing two-phase structure. The first phase is a draw period, wherein homeowners can draw from their credit limit much as they would with a credit card. During this five- to 10-year phase, borrowers are only responsible for interest payments.
When this phase ends and the repayment period begins, the total bill comes due: monthly payments on both the interest and the principal. Given that some borrowers may be approved for a six-figure credit line, these monthly payments can put significant financial strain on homeowners, leaving them to feel trapped by what was supposed to be the low-interest and low-risk solution.1
While HELOCs don’t intentionally aim to trap homeowners, this common pitfall underscores the importance of understanding exactly how these products work before signing on the dotted line.
A potentially confusing repayment structure isn’t the only reason why homeowners and some financial experts consider home equity lines of credit to be risky. If you’re considering using a HELOC to access funds, beware of these potential threats to your home equity.
Those exploring HELOCs are often cross-shopping home equity loans, which serve a similar purpose but dole out funds in a single lump sum rather than a line of credit. Because HELOCs allow borrowers to draw funds from a set credit limit consistently, some users may be tempted to borrow more than they need.
This over-borrowing isn’t always deliberate. Many homeowners will turn to HELOCs to free up some cash for costly home-improvement projects, which can work to increase equity over time. However, as a project grows more expensive and with more funds within arms’ reach, the urge to tap the line of credit once (or twice) more can grow too strong to resist.
The home equity line of credit is a popular choice for homeowners wanting to avoid the sky-high interest rates that credit cards, personal loans, and other loan products carry. Despite this, HELOC interest rates can still come with their own risk. This is because most home equity lines of credit feature variable interest rates, meaning monthly payments can routinely fluctuate.2
With unpredictable interest rates, it can be very difficult to develop (and stick to) a budget, potentially creating financial instability and getting in the way of other goals.
When you borrow money with a HELOC, you’re not technically borrowing from your home equity but rather against it. Therefore, you might not feel like you’re putting your home equity at risk of any immediate damage. But if you choose to sell your home before you finish paying off your loan, you may be left with less home equity than you had hoped.
This is because the terms of HELOCs generally state that the loan must be repaid when the home is sold. So, if you still owe on your loan, a portion of your sale proceeds may be devoted to clearing your debt.
A HELOC is far from a risk-free endeavor. But when you most need one, they can be great financial tools, helping you accomplish your goals while avoiding high-interest debt.
Every homeowner needs an emergency fund, or an account specifically created to address unexpected and unwanted expenses that may arise. For example: say your primary vehicle dies, leaving you without a means of getting to and from work. An emergency fund can help you tackle repairs or find a suitable replacement without having to go into debt, or pull the funds from a savings or investment account.
In an emergency fund’s absence, a home equity line of credit can help you address emergency expenses without resorting to credit cards, personal loans, or other expensive forms of debt, borrowing against your home equity instead.
As mentioned above, a HELOC can also be a great debt-management tool. If you’re struggling to stay on top of various debts from high-interest credit cards or personal loans, a HELOC may allow you to consolidate these debts into a single payment.
This can prevent your debts from snowballing, making them easier to manage and providing a clear path toward a debt-free life.
A home equity line of credit is most valuable when it can help you achieve multiple goals at once, such as funding costly home improvement projects while also boosting your home equity.
A new roof, an additional bathroom, a garage, and other home renovations can increase your property’s value, adding to your home equity in the process. Using this equity to fund these projects rather than taking on other forms of debt can help you save money, and may even come with a healthy tax break.3
You’ve weighed the risks and benefits and decided that a home equity line of credit is your best path forward. Now here’s what to do to get the most out of your HELOC while avoiding some of the common pitfalls.
The biggest “trap” homeowners fall into has to do with the HELOC draw period. Having a window where you can (in theory) take out as much cash as you want can be a major temptation to many borrowers, leading them to take out more than they need. As the borrowed amount gains interest it can snowball out of control, becoming completely unmanageable when the repayment period begins.
So, to avoid this common misstep, take extra care to only borrow what you need. Create a budget for your HELOC to ensure every dollar you borrow has a purpose, whether that’s financing a remodel or funding your emergency savings account.
Like with any loan product, understanding the fine print can be the difference between using a HELOC to your advantage and getting trapped with more debt than you want.
What should you look out for when combing through the fine print? Make sure you know your loan terms (like the lengths of your draw and repayment periods) and understand what happens should you decide to sell your home before your loan is repaid. Oftentimes, the smallest print can have the biggest impact on your financial future.
While some lenders offer fixed-rate HELOCs, variable interest rates tend to be the standard. So rather than waiting for your rates to fluctuate and then choosing to react, it behooves you to make a plan for these adjustments. Build them into your budget and navigate the ebbs and flows with confidence.
Overestimate your monthly payments during both the draw and repayment periods, ensuring you have more room in your budget than you need. In the best case scenario, this will free up extra cash to serve your other financial goals. Worst case, you’ll be prepared for these fluctuations, preventing your goals from being derailed by inflated monthly payments.
HELOCs aren’t for everyone. And maybe you’ve decided that though the benefits of a HELOC are appealing, the risks simply aren’t worth it. Fortunately, there are several other ways to access and leverage your home equity.
Enter: Truehold’s sell and stay transaction. With Truehold, homeowners can sell their homes in exchange for their hard-earned home equity. This could be a better path for those considering traditional equity unlock products like HELOCs and home refinancing.
Plus, you can continue living in the home as a renter while you plan out your next move—whether that’s retirement or just a stress-free break from homeownership.*
HELOCs are only as dangerous as how they’re used—or misused. But given the risks associated with home equity lines of credit, from homeowners overspending their way into debt to variable interest rates that can make it challenging to budget, it’s no surprise that many feel HELOC to be a five-letter word for “trap.”
If you’re looking for a trap-free alternative to the HELOC, Truehold’s sell and stay transaction could be a viable option.
Connect with one of our trusted representatives to learn more about our sell and stay transaction and see if this approach is right for you.
Disclaimer*: After the home sale, you must comply with the terms of your lease to continue living in the home. This includes making timely payments on your rent for your minimum lease term (which ranges from 6 – 24 months).
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