A home equity line of credit (HELOC) is a fairly common type of loan that allows homeowners to use their home equity as a revolving line of credit. In simpler terms, it lets you turn your home's equity into cash without selling the property. It works like this: Lenders loan a homeowner a percentage of the property's value – up to 85% in some cases, according to NerdWallet® – minus the amount of the existing mortgage. Like a credit card, the loan acts as a revolving line of credit for a draw period that usually lasts 10 to 15 years. Once that period is up, a repayment period usually lasting 15 years begins.
Most homeowners who leverage a HELOC do so with the intention of funding home-improvement or remodeling projects. Others will use it to help finance a child's college education, or as a way to cover a large expense such as the purchase of a new automobile. But what about financial emergencies? Is it advisable to use a HELOC loan to cover unexpected expenses?
Understanding the risks
Ideally, homeowners will have another source of emergency funds saved up that they can access more quickly than a HELOC loan. This is because there are several risks involved with a HELOC. First, a HELOC loan needs to be paid off once the draw period comes to an end. This may be problematic under certain circumstances, for example, if the financial emergency is induced by a health incident that may leave the homeowner unable to achieve gainful employment by the end of the draw period. A homeowner who is unable to make payments on the principal as well as the interest on the loan risks foreclosure.
Another factor worth considering is that a HELOC has a formal application and approval. It isn't the same as a savings account in that the funds are not immediately available. The borrower may need to pay a fee upfront, and time to closing may vary according to many factors, some of which are beyond the borrower's control. This means the applicant may need to wait weeks or longer before they can access their cash.
Note that most HELOCs also have an adjustable interest rate. This means that interest rates may increase with baseline interest rates, ultimately bloating your repayment obligations. Draw rates from your line of credit as well as your repayment rates may also affect your interest rates.
While the interest on HELOCs used to fund home improvement projects may have tax benefits, most other uses of HELOC funds will not land you a tax break, according to Forbes®. This includes interest on a HELOC for unexpected expenses such as last-minute traveling or sudden medical costs. Likewise, using a HELOC to pay off student loans or credit card debt at a lower interest rate will leave you ineligible for tax deductions on the interest payments.
The verdict: Best used as a last resort
The equity in your home can certainly act as a valuable source of funding, especially for home-improvement projects. However, the risks of using a HELOC as a source of emergency funding typically outweigh the benefits. Prudent homeowners may use a HELOC to fund unexpected expenses, but usually this is only for the most dire of circumstances in which no other option exists. Even then, repaying a HELOC depends on your ability to achieve some financial stability before the end of the draw period. If that is infeasible for any number of reasons, a different course of action such as a personal loan may be the better option.
There is a right time and a wrong time to use a HELOC as source of funding, and knowing the difference is half the battle. To learn more, contact the experts at Comerica Bank.
