What Are the Drawbacks of a HELOC?

A HELOC can be a powerful financial tool to pay off other debts or to fund improvements or other projects related to your home, but there are downsides to HELOCs that may make it risky to certain borrowers.

The downsides of HELOC include:

• Potential for Foreclosure. Like a mortgage, a HELOC forces you to use your home to secure the money you borrow. This means that if an emergency occurs and you cannot make your payments, the lender could seize your home. A HELOC is therefore very risky to borrowers who do not have a stable income.

• Potential to Go "Underwater." The potential to go underwater on a loan is a risk inherent to all loans secured against your property. When a borrower owes more than the value of the property against which the loan is taken, that borrower is said to be “underwater.” If your property decreases in value after you take out a HELOC, you might therefore owe more than the value of the house itself. If you choose to sell your house, you would have to pay the full balance on your loans, including a HELOC. Thus, if for some reason you need to sell your home, you would have to pay cash to cover the difference between the balance and the value of the home. This can be risky and unsound for many homeowners.

• Risk That the Lender Will Freeze Your Credit. If your home has decreased in value or if you have lost income and miss a few payments, the lender can choose to freeze your line of credit and prevent you from drawing on it further. Although you would not be forced out of your home, you would be unable to draw on your credit line to complete potentially required payments for certain improvements or repairs, nor could you access your HELOC to pay off other debts;

• Adjustable Rates. Most HELOCs are adjustable-rate mortgages, which means that your monthly interest rate payments for HELOCs will change over time. In many cases, this means that your monthly payment on a HELOC will increase over time and may go up rapidly. This can make it difficult to plan a budget while using a HELOC. You can prepare for adjustable rates by noting the interest rate caps set by your HELOC and determining the maximum monthly payment you can afford. If the maximum monthly payment you can afford is less than the cap on interest rates set by a HELOC, you should consider an alternative loan option to that HELOC, as the required payments may rise beyond what you could repay.

• Initial Costs. HELOCs often feature numerous fees and other associated startup costs. If you need to borrow a small sum of money, then a HELOC may end up costing you much more than other options for acquiring that money. The savings you get from a low interest rate are a key reason for taking out a HELOC; if you end up paying more in fees than you ultimately save from this interest rate, the HELOC is not going to be helpful to you. When you need to take out a small, short-term loan, a credit card (preferably with a low interest rate) can be a better source of credit. In some cases, however, lenders will waive the initial costs associated with a HELOC. Be sure to check the terms of your loan and determine the costs you will have to pay to set up the loan, estimate the savings you hope to gain from it, and weigh those costs against your potential savings.

• High Payment on Expiration. At the end of your HELOC's payment period, you will be required to pay the total outstanding balance in full. This requirement is referred to as a "balloon payment" and can be beyond the reach of many borrowers. If you cannot afford this payment when it comes due, you could default and the lender could seize your home. When the HELOC is close to the date of expiry, be sure that your outstanding balance on the HELOC is not beyond your means to repay.

• Renting Restrictions. Some HELOCs include terms prohibiting borrowers from renting out the home used as collateral while the borrower still owes money on the HELOC. Because this restriction prevents you from using the home to earn income or otherwise converting the home for use as a rental property, you will lose some flexibility. If for any reason you can no longer live in the property yourself, you will most likely be forced to sell the house rather than finding an alternative use for the property. At that point, you would be responsible for paying the full balance of the HELOC. A HELOC can therefore be risky and costly if you end up having to move during the HELOC's term.