In recent years, lenders have been consistently recommending the homeowner’s line of credit (HLOC) to consumers. On the surface, it looks like a great financial product since it gives homeowners quick access to their home equity at a low interest rate (3-4%). The line of credit can then be used for renovations, large purchases, holidays or even debt consolidation.
However, it is important for homeowners to realize that the HLOC is a double-edged sword. If used without further thoughts, it can negatively impact the financial growth of the household.
So what are the disadvantages of the home equity line of credit?
Firstly, it has an “interest-only” repayment requirement, which means, you only have to pay the interest accrued during the month, but none of the principal. For example, if you have a line of credit with a limit of $100,000 and a balance of $50,000, at 3%, you will only be required to pay $125/month. Although this might look like an advantage given the small monthly payment, it is actually the biggest drawback of this financial product. Because the lender will almost never ask you to reimburse the principal (in this example, the $50,000), you will technically forever be in debt, until you decide to voluntarily pay it back or sell the house. Essentially, the lender is counting on your own self-discipline to pay down your principal. But how many out there are disciplined enough to pay back more than their lender is asking them to?
Furthermore, I have seen numerous cases of households using their home equity as their emergency fund. Having a HLOC essentially makes families less motivated to accumulate an emergency fund made up of cash savings. In the back of their minds, they know that they can use their HLOC as a backup plan if an emergency were to occur. In my opinion, this is equivalent of turning your home into an ATM machine. Lenders have made the access to your home equity so reachable. With a few clicks, you can transform your home equity into cash. All you need to do is log in to your bank account online, transfer from your HLOC to your checking account, and you are suddenly cash rich. However, by doing so, you are technically taking a few square feet of your home that you already own and giving them back to the bank.
So how can you counteract these downsides? In numerous ways:
- I recommend to still aim for accumulating an emergency fund made of cash savings, to cover your next emergency (job loss, disability, roof leak,…). Do not count on your home equity to bail you out. Your home equity is simply there to increase your net worth.
- If you have to borrow from your HLOC, come up with a proactive plan to reimburse it within a certain timeframe. You can include in your monthly budget an amount to pay the required interest AND part of the principal. You could start with a few hundred dollars and increase it gradually until your principal is consistently decreasing.
- Avoid using it for consumption purposes, such as vacations, shopping and everyday bills. The best way to pay for such expenses is to plan for them in your budget.
- If you use it to consolidate other debts, establish a strategy that will allow you to not find yourself in a similar situation a few years from now. This will prevent you from using your home for a 2nd debt consolidation down the road.
Using your homeowner’s line of credit to bail you out of life’s financial surprises is certainly not optimal. A more comprehensive plan is required so you can make financially sound decisions. Your goal should be to ultimately grow your wealth rather than shrinking it through borrowing.
this article was originally published in the newspaper The Chronicle on August 27th 2014. – Home Equity Line of Credit
