Many years ago, we bought our first home.
It had an unfinished half basement, which we wanted to finish.
Not having the funds to cover that, we opened a Home Equity Line of Credit, or HELOC, and used that to pay for the upgrade.
We planned to gradually pay off the balance. But then life happened. Unexpected medical and dental expenses, high-cost home repairs, car repairs, some business expenses, some college tuition bills, and each time we dug ourselves just a little further into the HELOC hole.
Yes, the interest was still tax deductible at that time, and yes, we could afford the interest-only payments.
But that was because our interest rate was sub-3-percent. Given how long this went on, we were more lucky than smart. Had interest rates spiked to, say, six percent, our payments would have doubled and then some.
Had we run out of the 10-year draw period, and entered the repayment period in which we’d have to start paying off the balance owed on a 10-year amortization schedule, our payments would have tripled or more.
Had both those happened together, our payments would have increased more than four-fold.
Had any of these happened, we’d have been in serious trouble. Potentially losing-our-home serious.
The Structure of the Typical HELOC
A HELOC is a loan secured by your home, as is your mortgage. If you default on either your mortgage (if any) or the HELOC, the lender(s) may foreclose your home (read, you’ll lose the home)
If that happens, the lenders sell your home for what they can quickly get, take the balance you owe them plus any fees and interest, and give you any leftover funds. In such a scenario, your mortgage lender gets their part first. Then, out of what’s left, the HELOC lender (the same or different bank) gets theirs (assuming enough is left over). Then, if anything remains, you get the scraps.
The main difference is that you can open a HELOC and not draw anything from it. The HELOC is set up with typically a 10-year draw phase (though it can be as short as five years or as long as 15) during which you can borrow at will up to the HELOC limit, and typically a 10-year repayment period (it could be as long as 20 years).
In the draw period, you’re required to pay at least the interest accrued on amounts you’ve drawn, and if you choose to, you can pay down the principal owed.
Once the draw period is over, the line of credit closes, and the balance gets converted into what’s essentially a variable-rate mortgage, where you have to pay interest plus principal each month, paying the balance off in full by the end of the repayment period.
Another difference is that most mortgages in the US are 30-year fixed-rate mortgages, while most HELOCs are variable-rate. That means if interest rates go up, your payment increases, potentially by a lot, just like could have happened to us.
Welcome to the HELOC Trap
As I described above, it’s too easy to dig yourself into a deep hole with a HELOC, especially if you can easily afford the interest payments. It’s when the draw period ends and/or when interest rates spike that you may realize you’re in way over your head, and could lose your home.
Danielle Miura, CFP®, founder and owner of Spark Financials, explains, “Most HELOCs have rates that adjust based on the market changes of the so-called Prime Rate. As interest rates increase, so does your monthly payment. A larger monthly payment means you have less money for other things, like paying your bills or saving for retirement.
Unfortunately, there’s no way to predict how high interest rates will go. If your interest rate increases dramatically, it could make your monthly payment unaffordable. Not making your monthly HELOC payment can lower your credit score, increase the interest you owe, and potentially cost you your home. If your HELOC agreement doesn’t specifically state it’s fixed-rate, it will state the maximum interest rate you could be charged.“
5 Ways to Escape a HELOC Trap
If you’re concerned rising interest rates may make your HELOC payments unaffordable, and you can’t pay off your balance in full, you have to find a way out.
My way out was to refinance our mortgage with enough cash out to pay off our HELOC. However, that was only feasible because mortgage rates at the time were lower than my then-existing mortgage.
These days, your existing mortgage (if any) probably has a lower interest rate than you’d be able to get in a refi, so that option is likely off the table for you.
However, here are five other options. All of these would have been better done before interest rates rose, but you may still choose to use one of them if you’re afraid further rate increases will make your HELOC payments even less affordable.
Danielle Miura suggests first trying to convert your variable-rate HELOC to a fixed-rate one. She says, “Depending on the lender, you might be able to transfer some or all of your loan to a fixed-rate HELOC. This might be a good move if you want to lock in a fixed rate and a more predictable monthly payment.”
Her next suggestion is to convert your variable-rate HELOC to a fixed-rate home equity loan. She cautions however, “Even though a home equity loan may seem like an ideal solution, it’s important to consider that you’ll need to pay closing costs. Second, your home will be used as collateral for the new loan too, so if you can’t afford the resulting monthly payments, you may still lose your home.”
If you want to take losing your home off the table, Miura says, “You might consider taking out a personal loan to pay off and close your HELOC. However, depending on your HELOC balance, you might not be approved for a loan large enough to pay it off in full. In addition, personal loans usually come with extra fees and higher interest rates since the lender doesn’t have the security of your home as collateral if you default.”
For those whose credit score is too low to qualify for a new loan to pay off their HELOC and who can’t afford the increased payments resulting from the current higher interest rates and/or the even higher ones we’ll likely see over the coming months, Miura suggests, “Contact your loan officer, explain your situation, and ask them to modify your HELOC. Lenders don’t have to help you, but it’s worth a shot.”
Finally, if you’re over 62 years old and the combined balance on your mortgage and HELOC is low enough relative to your home’s value, you could look into a reverse mortgage for paying off both, and then not have any monthly payments.
According to American Liberty Mortgage, you can keep the excess of your approved amount as a line of credit, and as interest rates go up, your available line of credit will go up.
However, make sure you fully understand all the consequences of taking out a reverse mortgage. For example, reverse mortgage interest rates and fees are higher than those of normal mortgages. Also, you will likely need to pay back the loan if you move.
Finally, the money you borrow will have to be paid off when you pass away. If the amount owed is higher than the home’s value at that point, your estate and heirs won’t be liable for the excess balance, but the home will be lost.
One crucial detail to note is that some HELOCs have a prepayment penalty if you pay them off within the first few years of the repayment period. Make sure to read the fine print of your HELOC carefully, so you know whether it has such a penalty, and if so, how much it would be.
The Bottom Line
HELOCs are a convenient way to have a line of credit that usually has much lower interest rates than credit cards.
However, differently than credit cards, HELOCs are secured by your home, which means you could lose your home if you default on the HELOC.
HELOC interest used to be tax deductible no matter what you used it for. That changed with the 2017 Tax Cuts and Jobs Act (TCJA). Since 2018, when that act came into effect, you can only deduct your HELOC interest if the funds are used to buy, build, or substantially improve your home.
Most HELOCs have a variable interest rate, which can turn the HELOC into a trap when interest rates spike, because your monthly payments can easily double or more. If you’re in such a situation, the above offers several options to extricate yourself from the HELOC trap.
This article is intended for informational purposes only, and should not be considered financial, investment, business, tax, or legal advice. You should consult a relevant professional before making any major decisions.