Q&A: Pros and Cons of Home Equity Line of Credit

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Question: My wife and I are considering a home equity line of credit. Our house is worth about $400,000, and we owe about $100,000. We recently refinanced at 4%. What are the pros and cons of an equity line of credit? What questions should we ask our lender first? Are there any hidden fees we should be aware of?

Ric: A line of credit is like having a credit card, with the bank telling you that it will allow you to borrow up to a certain amount — say, $100,000 or $200,000 — and it won’t charge you interest until you use it.

That’s different from a home equity loan, where the bank lends you the amount you request, and you begin paying back the loan immediately with interest.

With the line of credit, you can pay off in full what you borrow each month — again, much like a credit card — or you can make monthly payments. The difference is that this loan is tied to the value of the house; the house is collateral. If you default on your Visa credit card, there’s nothing Visa can do about it, but if you default on a HELOC the bank can take your house. The good news is that the interest rate is lower and usually tax deductible; the bad news is you could lose your house if you don’t repay the loan.

Another advantage is that the line of credit can bail you out of a tough financial situation — say, in the event of a job loss, a medical crisis or an unexpected major repair. It provides a cushion for that. But don’t assume that it’s a substitute for cash reserves. We have heard people say, “I don’t need to have cash reserves because I’ve got a $100,000 line of credit.” That’s wrong — for the simple reason that the bank can cancel the line of credit at any time.

In 2008, that’s exactly what many banks did. People who thought they were secure because they had a line of credit were shocked when they got letters from their banks saying, “We’re canceling the line because your house has fallen in value.” And if the bank finds out that you’ve lost your job, it will likely cancel the credit. In other words, the very moment you need it, it’s no longer there.

So, yes, go ahead and get a line of credit, but don’t pretend that having a line means you don’t need cash reserves; you still do.

As for fees, well, there are no hidden fees, but there are fees nonetheless. You’ll probably spend a couple grand to acquire the line of credit. Also, some banks will charge fees if you don’t immediately use the line, because banks earn money by lending money and receiving interest on it; if your bank grants you a line of credit you don’t use, the bank isn’t making any money and may therefore impose a fee.

So, simply ask up front, “What are the costs of obtaining the line of credit? What are the monthly costs of maintaining it? What interest rate will you charge when I do use it?” Then shop around at different banks to find the best deal. It’s fairly easy to do.

One final point: Sometimes people ask, “Ric, should I get a mortgage or a line of credit?” Well, a line of credit is a mortgage. Both are loans secured by the house.

Originally published in Inside Personal Finance February 2015

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