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A home loan that's easy to carry. Or not

Home-equity lines of credit come with easy terms and low interest rates. Don't believe it.

August 18, 2005 : 5:07 PM EDT
By Justin Martin, MONEY Magazine

NEW YORK (MONEY Magazine) - Even if you wouldn't dream of running your credit-card balance through the roof, chances are you have no qualms about borrowing heavily against the roof over your head.

And why not, when you can so effortlessly take out a home-equity line of credit, or HELOC, and draw on it as needed up to a preset limit? They're fast, simple and, given booming home prices, seemingly inexhaustible.

To be sure, we've often said on this Web site and in our magazine that they're good for certain things. But there are ways that these seemingly innocuous loans can come back to bite you.

Risk No. 1: Those low payments balloon

HELOCs are structured as interest-only loans, so the minimum payments can be enticingly small. Currently, someone with a balance of $36,427 (the national average) would owe only about $200 a month. Put the same amount on a credit card charging 13 percent and the minimum would be around $1,000.

While a HELOC's interest-only payments feel relatively painless, they have a serious downside: You're not retiring any principal. If you borrowed $20,000 the day you opened the line of credit, you'd still owe $20,000 when the interest-only payoff period ends, generally after 10 years.

At that point, you would have to start paying down the principal, which means your monthly payments would spike. Of course, you could roll the balance over into a fresh HELOC. Many people do.

"The risk is that you make small payments on a big debt forever and never make a dent," cautions Fritz Elmendorf, vice president of the Consumer Bankers Association. The solution: Start paying off the principal in advance by exceeding your minimum payment each month.

Risk No. 2: That low rate rises

You may figure that even if interest rates edge up, the hike will barely register on your monthly HELOC statement. But interest-rate moves tend to happen in clusters as the Federal Reserve seeks to get the economy on track.

Since June 2004 the prime rate, which HELOCs are pegged to, has climbed from 4 percent to 6.25 percent. The results are quite visible: On that $36,427 average HELOC balance you'd pay about $70 extra a month.

If rate hikes continue, as many experts expect, it will be like water torture for HELOC holders.

"A quarter point here, a quarter point there, and soon you start to feel the pain of significantly increased monthly payments," says Keith Gumbinger of HSH Associates, a financial research firm in Pompton Plains , N.J.

The solution: If you expect to take more than three years paying off your debt, skip the HELOC and use a fixed-rate home-equity loan instead.

Risk No. 3: You're hit with hidden fees

Increasingly, banks are burying extra costs in the fine print. One of the most onerous is the early-termination fee, aimed at consumers who jump from loan to loan in search of better terms.

In response, lenders have begun to charge a fee if a line is closed within a specified period, typically three years. Today more than 60 percent of lenders have early-termination fees vs. around 45 percent in 2000, according to HSH Associates.

Usually an early-termination fee is a few hundred dollars. But some lenders charge a percentage of the outstanding balance or even force people to fork over transaction costs that were supposedly "waived" when the credit line was first opened. Either of these scenarios can end up costing you thousands.

The obvious loophole is to keep the line of credit open with a balance of zero or a few dollars rather than closing it down altogether, but lenders have thought of that. Accounts that remain open but unused for a set period (usually one year) get stuck with inactivity fees, typically around $50. You can also expect to pay an annual fee, again about $50.

The solution: Shop around for a lender that doesn't impose heavy fees -- or at least be aware of the fees written into your loan and avoid them.

Risk No. 4: You lose your equity

Most HELOC tappers assume that some day they'll just sell their home and the loan will effectively disappear. But there are no guarantees -- and there doesn't have to be a bubble for this assumption to put your equity in danger.

Let's say you bought your house for $200,000 but it was recently appraised for $300,000. Sell for anything close to the appraised value and you'll reap a tidy profit. Now throw a $75,000 HELOC balance into the equation. Suddenly the local market need only sag a bit and you can be in trouble, unable to net enough on the sale of your home to pay off both the mortgage and HELOC balances.

"You can wind up in an unenviable position, selling your home and writing -- rather than receiving -- a big check," says Greg McBride, an analyst at Bankrate.com, a personal-finance Web site.

The solution: Leave yourself an equity cushion of at least 20 percent.

Risk No. 5: You borrow and overspend

No question, HELOCs offer better rates than bank loans, credit cards and most everything else out there. But whether they're truly a good deal depends on how you use the money.

In a 2004 survey by Synergistics Research, based in Atlanta , 57 percent of respondents reported using HELOCs for home improvement. This can be a sensible use of HELOCs, as can some debt consolidation (cited by 35 percent of respondents) and paying for education (13 percent).

"If you're going to pull money out of your home, make it count," says Nan Sabel, a financial planner in Bedford , Mass.

But what if you are simply siphoning off your home's equity in order to live beyond your means? According to the Synergistics survey, for example, 13 percent of HELOC holders have tapped the lines for travel or other leisure pursuits.

Bottom line: Your Hawaiian idyll will truly be more than just a memory if you end up paying it off over many years with interest.

The solution: Resolve to use your HELOC only for expenses with long-lasting benefits: education, home improvement or debt reduction.

Loan or line of credit?
While the similar names provoke confusion, HELOCs and home-equity loans are actually quite different. Here's how to tell them apart -- and how to use each of them wisely.

  Home-equity line of credit  Home-equity loan
What is it? An open line of credit, with a set limit and a variable rate, to draw on as needed.  A fixed-rate loan delivered in one lump sum. 
Average rate [1] 6.62%  7.22% 
Pros Flexibility. Now offered at lower rates than loans.  A fixed rate means you know what you'll owe. If you pay on time, it won't hurt your credit score. 
Cons Variable rate can creep up. If you max out your line, it'll hurt your credit score.  Currently, higher rates than lines of credit. 
[1]As of June 24.
Source: HSH Associates.

 

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