By – Robb Nelson
Loans secured against your home have been the hot product for a while now at all major lenders. They are presented in the form of a HELOC, or Home Equity Line of Credit, and are frequently how lenders will suggest you finance any major loan whether it be to send your kids to school, renovate your home, or purchase a new car. For people who are getting a new mortgage, lenders like to suggest a hybrid mortgage that incorporates a HELOC in with a traditional mortgage so, as the balance on the loan reduces, the amount you can borrow on your HELOC will rise. Now the question here is: Is this a good idea?
People look favourably at HELOCs because they are easy to get if you have a good amount of equity in your home and have a decent credit history. They work in the same way that a credit card does where you are only paying interest on the amount that you owe, and the upside is the interest is much lower that you would receive on a credit card. HELOCs are also less expensive than getting a personal loan because, from the lender’s perspective, the collateral is already there in your home and they vetted you when you applied for the mortgage so they are usually confident that you are able to pay that amount back. HELOCs also make it easy to access the funds, whenever you need you have the ability to write a cheque or use a credit card associated with the line of credit.
Now this all sounds like a pretty good deal, right? You are going to use a line of credit that has a low interest rate, is easy to access, and you can use the funds for whatever you want. However, you have to be very careful when dealing with HELOCS. What’s the limit on your credit card? On average, people usually have it at between $5,000.00 and $10,000.00. Why not more? Why don’t you have multiple credit cards reaching into the tens or hundreds of thousands of dollars? It’s because it’s too much credit, too much money to have at your finger tips without the need to actually being able to afford the purchases you’re making. The reason that you go into a lender to ask for a loan for a major purchase is not solely because they are the ones with the funds, it’s because they are the ones who can advise you what you can actually afford to pay back.
As mentioned before, when you get a HELOC or your mortgage is a hybrid mortgage where a HELOC is blended in, one of the advantages is that the lender is confident you can pay back because it is secured against your home. Having a loan secured this way is a double-edged sword because if you default on the HELOC you could lose your home. This makes it extremely important to make your payments on time. The interest rate on such debt is also variable so there is a possibility that, if your home value falls, you could end up owing more than your home is worth. This is known as being “upside down” or “underwater” and it means that you will not be able to refinance the mortgage and selling your house will be much more difficult. Finally, far more often than not, when a HELOC payment schedule is drawn up they only ask that you pay the interest on the loan. This means that the principle is not getting paid off and your debt will keep growing and growing, all the while not paying down your mortgage.
The bottom line is that a HELOC is basically a large credit card that allows you to make major purchases without needing to consider your ability to pay it back. Having a process that is needed to go through in order to acquire any significant loans is an important step as it stops you from getting in a financial situation that you are unable to get out of.