There may come a time in life when you need a large amount of money and you’ll probably consider taking out a loan. Which banks are the best to work with? What interest rate is fair? Are the loan payments affordable? Accessing the equity in your home can be a more attractive option. The equity built up in your home presents two potential pathways to gaining access to cash.
Opening a Home Equity Line of Credit (HELOC) is like opening a credit card with a variable interest rate that you can borrow against at any time. Once the HELOC is opened, the equity is available for you to take as you need with the expectation that you will pay the amount back with interest. This can be a great option for households that had an unexpected large expense arise that needs to be paid quickly. The downside of utilizing your HELOC is that you are using your home as collateral, and if you default on the payment, you can face foreclosure on your home.
The other option is a Home Equity Loan. Though the name sounds similar, it is not quite the same. These loans also use the equity available in your home, but they are fixed loan amounts with a fixed interest rate that will be paid back over time. This is less accessible than a HELOC and, depending on the market conditions, could result in paying a higher interest rate. This strategy also uses your home as collateral and is essentially a second mortgage payment.
It is crucial you thoroughly consider all your options before committing to any type of loan that uses your home as collateral. Not doing this can have major consequences for your family and your financial health.
For example –
Leon and Amy have lived in their home for five years and have been happy to watch the market value of their home rise. They received a special offer from their lender in the mail to open a Home Equity Line of Credit (HELOC) for a low interest rate of 2.65% for 12 months, which was lower than any personal loan they could get. They had always wanted to own a boat and decided this was the perfect opportunity to make that dream a reality. They purchased a brand-new pontoon style boat with a roof for $38,999 with the intention of paying off the HELOC in 12 months. Leon had just started a new job and his paychecks were bringing in quite a bit extra income per month. He also expected to earn a large bonus at the end of his first year that would allow them to pay off most of the balance. They looked forward to taking their friends out in the boat on a nearby lake, and spending quality family time together.
One month later, Amy got laid off from her job and she was unable to find another job with a comparable salary for months. During this time, Leon’s income had to supplement their basic expenses, so they were only able to pay the interest on the HELOC every month. They kept expecting to bounce back the following month but could never quite get ahead. At the end of the 12 months, Amy was working again but was not making nearly as much as before. They were still recovering financially from the lack of income over the last year. On top of that, the variable interest rate on their HELOC increased significantly due to market interest rates rising. They had only taken the boat out once, as their limited income made it difficult to cover the extra expenses of gasoline, boat maintenance, fees to put the boat in the water, and insurance. They felt completely defeated by this constant reminder of their financial restraints sitting in their driveway. They had hardly touched the principal of the loan over the last year and the boat’s market value has decreased, putting them in the red on the entire purchase. Amy was especially concerned because the HELOC used their home as collateral, which felt like a threat to the home where they had started their family and had many happy memories. After consulting with their advisor, Leon and Amy decided that having a stable home was worth more than owning the boat. They sold the boat to recover as much money as they could and pay it toward the HELOC. Then they would commit to pay the rest of the HELOC over time.Talking with a financial advisor could have helped Leon and Amy review all their options for financing the boat and weigh the pros and cons before making this type of impulsive, passion-driven purchase. We recommend reviewing these decisions with a financial advisor to determine what the best step would be.
GW Financial, Inc. is a fee-only firm and offers a complimentary Getting Acquainted Call to help set you on the right path. Click HERE to schedule a 30-min personal check-in.