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Experiences and advice on personal finance issues. From credit cards over credit scores to mortgages and real estate investing.
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Generated 20:00:58 on Oct 27, 2020
Risks of HELOCs (Home Equity Lines of Credit)
Question: I am thinking of purchasing an investment property and want to make the down payment using a HELOC (Home Equity Lines of Credit) on my primary residence. What are the risks of HELOCs?
Answer: Since you will use the HELOC to buy other real estate, you are actually doing ok. One benefit will be that the interest you'll be paying on that HELOC will be tax-deductible. Sometimes people use a HELOC to finance a lifestyle that is beyond their means (expensive travel, vehicles, plasma TVs) - strictly speaking the interest on a HELOC used this way will not be tax-deductible.
Getting a HELOC is easy. There are 3 risks associated with it:
- HELOCs are often structured as interest only, thus you are not paying down the principal. Look at your bank's statement when you your payment-due notice. Does it include any principal? It's a good idea to pay a little more whenever you can afford it.
- As the Fed raises the interest rate, HELOCs follow. My credit union's term is that the HELOC rate gets adjusted on the next first of the month after the FED adjusted the prime rate. At the time of writing (summer 2005) this is not a time to hope for falling interest. Most experts expect at least two more hikes of 0.25% each. This means your minimum payment will rise.
- You lose equity in your house and may even end up 'upside down'. That is if you own a house worth $500,000 and you have a mortgage of $400,000 on it and a HELOC of $50,000. Now your total balance is $450,000. Let's say you need to sell the house and the price drops just a bit - by 5% - to $475,000. Then there is 6% real estate agent commission to be paid.. that alone will be $28,500. I won't even add in the cost to clean the house / make it ready for a sale.
$475,000 sale price
- 28,500 transaction cost
-400,000 first mortgage
- 50,000 HELOC
Now imagine what happens if the house price drops 10%. Not unrealistic at all.
However a HELOC is a good idea when you need to pay off credit cards (debt consolidation) since the interest rate is so much lower. Just make sure to change your spending habits or you'll be needing a second (or bigger) HELOC soon.
Also know that if you obtain a HELOC of $100,000 and you don't actually take out all the $100,000, maybe you only take out $12,000. If someone pulls your credit and looks at your loan-to-value ratio, they count your HELOC as $100,000 (because that's how much of a lien is against the property). It does not help you much that you only use $12,000 of the $100,000 line.
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