Tuesday, July 10, 2007

Home Buying Series Part V: Should you get a HELOC?

Now that you have found a house you can afford and decided on a mortgage, your mortgage broker may ask you if you would like a Home Equity Line of Credit (HELOC). If you are just buying this house for the first time (with 20% down as suggested earlier in this series), I would advise saying, "No thanks."

However, if you have been in your home for several years, have significant equity in the home, and find yourself in a couple of situations I would consider a HELOC. First, if you plan on investing in something that will pay for itself (new insulation for instance) over a long period of time a HELOC could make some sense as it would allow you to start reaping the benefits now. Note: there are very few investments you will make in your house that have this kind of return. Second, if you find yourself with significant credit card debt and the HELOC is offering a much lower interest rate it may make sense to use the HELOC to pay off those cards at a lower rate. Finally, if you need a new roof and you don't have any cash to fix it a HELOC might be your only good option.

HELOCs are basically just ARMs but they generally float right away. They are a fixed line of credit that you can draw on a little at a time, pay back, and then draw again up to your maximum like a credit card. You can choose to only pay interest on them for a certain period of time (typically 5 to 10 years) and then they begin charging principal too. The interest on HELOCs is generally tax deductible up to $100k. In my opinion HELOCs are generally to be avoided, though you can see a couple cases above where I might consider making an exception.

Home equity loans are another, possibly better option, but they are usually just a lump sum. You can't draw on them, then pay them off, then draw again. The good thing about home equity loans is that you can get them in a fixed interest rate (basically this type is just a second fixed mortgage). If you are using some of your home equity to invest in your home for a one time project (like the insulation mentioned above) a home equity loan with a fixed payment might be the way to go so you avoid monthly payments that bounce around.

The big risk with both of these options is that they provide you with the opportunity to overextend yourself and risk losing your home. If for some reason you can't pay your HELOC or home equity loan, you have a good chance of ending up in foreclosure since both products involve a lien on your house. I'd advise avoiding both products altogether unless you have a compelling need to use them.

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