The danger of running up your home equity line of credit
If you’ve got equity built up in your home, why wouldn’t you tap into it to cover expenses, pay for home renovations or other things?
“Although Home Equity Lines of Credit (HELOC) can be a better choice when it comes to borrowing money because of lower interest rates, if you carry a high balance, you may be backing yourself into a financial corner,” says Jeff Schwartz Executive Director, Consolidated Credit Counseling Services of Canada.
HELOCs are subject to fluctuation in interest rates, so the recent increases to interest rates will raise payments. Similarly, in some cities in Canada (like Toronto) home prices have pulled back in the past few months.
Heavily indebted homeowners could be faced with a double whammy: the money that they’ve borrowed against their house will cost them more to repay, and therefore their monthly payments; at the same time, the value of their homes will decrease.
“If you haven’t left much wiggle room with your budget or if you’ve borrowed a sizeable amount against your home, rising interest rates and lower home prices could mean that you end up owing more than you own,” says Schwartz.
Before you tap into your home’s equity, here are some points to consider.
Potentially dangerous features
Some of the features that make the home equity line of credit so appealing are exactly the same features that can make it a dangerous credit product for those who are not being vigilant with their credit use.
HELOCs are subject to automatic credit increases (often granted without the homeowner even requesting an increase). They also are very convenient to use. Both of these features mean that it’s very easy to spend beyond your means.
Homeowners have the ability to make interest-only payments, which gives them a false sense of the actual debt amount that they owe. Don’t forget that when you’re making interest only payments, you’re doing absolutely nothing to reduce the actual principal of your debt. These variable payments can also present challenges with budgeting.
Remember, HELOCs are secured against your home. If you can’t afford to make your payments, your lender can AND will come after your home.
If you’re going to use a home equity line of credit, you’ve got to have a plan before, during and after you take the debt out. What are you using the debt for? How will you manage it? What is your plan and your timeline to pay it down? You should only borrow money against your home as it fits within your budget and is reasonable to pay down in a shorter timeframe.
Your HELOC is not your emergency fund
With the low interest rate environment of the last decade and consistently rising home prices, it seems reasonable enough for homeowners to rely on their HELOC in the event of emergency expenses. This mindset is momentum for a downward home equity debt spiral. If you’re relying on your home to cover costs in an emergency (i.e. unexpected expenses or interruption of income) then there is a good chance that you’ll need to turn to more debt in the future.
Have cash on hand and not debt for your emergency fund.
HELOC for renovations or major purchases
Before you automatically turn to your HELOC, what other options do you have to cover expenses or fund purchases? Can you turn to savings first to at least reduce the amount that you borrow? Can you defer purchases (or spread them out) so as to minimize your reliance on credit? As a rule, try to keep the gap wide wherever you can between how much you owe against your house and how much you own in order to protect yourself financially.