Home Equity Line of Credit (HELOC) - The Credit Card Mortgage
Home Equity Line of Credit (HELOC) – The Credit Card Mortgage
On the surface, HELOCs look like a great product for people. They have low rates. The interest is tax deductible if funds are used for home improvements. You can access a lot of money and enjoy low monthly payments because of the interest-only feature.
And, there's certainly a lot of "access" when you consider the higher credit limits allowed on HELOCs than what comes with the more common bank product – the credit card.
Based on your home's equity level, the bank gives you a line of credit, which you draw from using a checkbook. These are usually set up as 20-year loans with interest-only payments for the first 10 years (the draw period) then principle and interest payments the remaining 10 years (the repayment period – no more draws).
HELOCs are so much fun
You can use a HELOC to pay for anything! Pay off credit cards, do some home improvements, buy a car, pay for college . . . sometimes people are even tempted to pay off their mortgage with them!
You know something else? With a credit card, you know you're using money you don't have. With a HELOC, there's this feeling you're borrowing from yourself somehow.
What's not to love, right?
Here's the real truth: HELOCs function in much the same way as credit cards but can do considerably more damage. Here's how:
1. You have access to BIG money
Because there's no collateral for them, credit cards generally have $10,000 to $15,000 limits (a little more if you have excellent credit). HELOCs, on the other hand, can go up to $100,000 or more. The problem? Just like credit cards, the more you owe on a HELOC, the more trouble you're in.
2. The interest is calculated just like a credit card
Here's what people often don't understand: the interest is compounded. This means interest is charged on top of interest.
Compound interest is very different from simple interest. With a conventional mortgage, you're charged simple interest, meaning you're charged interest only on the amount borrowed. Using what's called amortization, the loan is structured so that in the beginning a greater percentage of your monthly payment goes toward interest and over time more and more of your payment is applied toward principle. The longer you hold the loan the less interest you actually pay.
With compound interest time is never on your side, if anything it's working against you. Compound interest works wonders when you're saving money but it works against you big time when you're borrowing money. This is why it's so hard to pay down credit card debt.
3. HELOCs are hard to PAY OFF
If you thought paying off a bunch of credit cards was tough, try paying off a big ‘ol HELOC. Refinancing doesn't always solve the problem either. The reason is the artificially low "interest only" payment on the home equity line.
Let's say you want to refinance. Your mortgage is $1500 and your HELOC is $200 per month. That's $1700. If you refinance them together, your new payment will probably be higher – because a mortgage payment is principle and interest. You can't pay just the interest forever.
No other type of loan (auto, mortgage, installment loan, etc.) has an "interest-only" payment structure – only credit cards and HELOCs.
4. Consumer protections don't apply to HELOCs
In 2009, Congress passed the Credit Card Accountability Responsibility and Disclosure Act. It's a consumer protection law that requires credit card companies to state how long it will take you to pay off your credit card balance if you make only minimum payments. This law also forced credit card companies to increase the minimum payment amount to prevent consumers from languishing in debt forever.
These protections do not apply to HELOCs.
And, while the new bank-policing Consumer Financial Protection Bureau (CFPB) has outlawed interest-only mortgages because they're so troublesome to consumers, their restrictions don't apply to HELOCs.
5. The party ends eventually -- HELOCs have a maturity date
At some point, you're going to have to pay the piper. HELOCs have a 10-year maturity date. If increases in the prime rate don't get you first, your maturity date will.
Once your HELOC matures, the draw period of the loan expires and the entire balance at that point converts to a 10-year installment loan at prevailing home equity loan rates – which are higher than first mortgage rates. At this point, you can kiss that low interest-only payment goodbye.
So let's call HELOCs what they are. They're not "smart money." They're not "borrowing from yourself." And they're definitely not "low payment forever."
They're credit card mortgages.
If you need help getting out from under a nasty HELOC, give us a call. One of our Loan Officers can answer any questions you have and help determine if a refi is right for you.