Is it a good idea to take a Home Equity Line of Credit (HELOC) as a safety net in case you need emergency cash?
Now that refinance business has dropped off a cliff due to the higher interest rates, lenders are soliciting homeowners to open a HELOC.
A home equity loan is a second mortgage that is secured in second position behind your main mortgage. If you were to default on your mortgage causing the home to be foreclosed and sold at auction, the main lender would be paid first. Then if there was enough money from the sale, the second mortgage holder (the lender who did the HELOC) would get paid.
Because it is riskier to take second position, any second mortgage has a higher interest rate. Because most people don’t like high rates, the HELOC is set on an adjustable rate mortgage. You set the loan for the maximum amount of cash you might want, then you are given checks for withdrawing money as desired.
An adjustable rate mortgage (ARM) begins at a lower rate than a fixed rate mortgage, but later it can go quickly and significantly higher.
How much higher? That depends on the terms, which you need to be aware of before signing. Here are questions to ask:
- What is the start rate?
- When will the interest rate be first adjusted and how often after?
- What is the index? (This is what the rate is based off of.)
- What is the margin? (The index + the margin = your new rate when it adjusts.)
- What is the lifetime cap? (The max rate it can go up to.)
- Is there a prepayment penalty? If so, what are the terms?
Those are six essential components you should understand before signing.
Here’s an inside tip: The lender makes a bigger profit by giving you a bigger margin. Most borrowers don’t pay attention to the margin and many loan officers don’t bring it up if you don’t ask. The margin is negotiable on some second mortgages, and it is a crucial part of the loan. Some banks have the margin set in stone so there is no negotiation, but you need to understand what it is and how it works.
Lifetime cap: It’s not unusual to see a very high rate such as 19%. If you have cash out and the rate goes that high, how will you handle the payment? If you do not pay your HELOC, they can foreclose on your house even if your main mortgage is paid 100% on time.
Prepayment Penalty: This is a big “gotcha” in California. In Washington state, a prepayment penalty on a second mortgage is illegal. If your HELOC will have a prepay penalty, then ask, “What is the worst case scenario?” Loan officers are famous for minimizing the affect of a ppp, saying “it will never happen to you,” “it’s not a stopper,” and other nonsense.
WHO SHOULD GET A HELOC?
In my opinion, only people who have had top tier credit scores for at least three to five years should get a HELOC. Why?
Because in my 22 years of working in the mortgage industry and in doing loans in 25 states for all types of credit profiles, it is my experience that only people who are fiscally conservative will handle a HELOC in a manner that does not work against them.
For many people, having a HELOC is like an alcoholic having a bottle of vodka in the house. They can’t resist using it for something they would like to have but cannot afford. They don’t have the patience to save cash, so they go into debt for a non-essential big ticket item.
If you maintain excellent credit and have a low debt-to-income ratio and want to take a HELOC, then ask the six questions above, then you will have the information to make an excellent choice. Best sources for a HELOC are midsize local banks and some credit unions. Personally, I like Banner Bank for HELOCs.