When we need money we generally look to borrow it using debt as the source. So, why should you get an equity sharing product when you can get into debt, instead? It is a fair and legitimate question and we are happy to address it with you. First, we need to look at your options. Homeowners get the best rates available if they’re willing to pledge their home as collateral. If you are a homeowner looking to get some liquidity without selling, HELOCs, home equity loans, and reverse mortgages are going to be your primary debt-based solutions. These traditional debt tools are fairly popular and well known among homeowners and lenders. What may or may not be known by most are the limitations and challenges associated with such methods. Let’s dive in and analyze some of them, starting with HELOCs.
HELOC is an acronym for Home Equity Line of Credit. This kind of loan is not designed to provide a fixed dollar amount; rather, it is the promise of the lender to advance you up to a certain dollar value, in the amount, modality and time you end up choosing. If you have an outstanding first mortgage, the HELOC will be your second mortgage. Draw periods can vary from 5 to 10 years. During this time, the borrower is only required to pay interest. The actual repayment periods go from 10 to 20 years, during which the borrower is required to make payments to principal equal to the balance at the end of the draw period divided by the repayment period calculated in months. The HELOC balance may change from day to day, according to draws and repayments; interests are adjustable and are calculated daily.
Now that we have a general view of what HELOCs are, we’ll look at some of the drawbacks and how they can impact homeowners. Interest rate variations can highly impact the cost to the consumer and represent the primary risk. HELOCs can get very expensive in an unfavorable interest rate environment. Even if you do not actively use a line of credit, you still have to pay fees to keep it open and accessible. In a housing crisis, your ability to draw from the credit line may be reduced or even eliminated. HELOCs are connected to home values. If they drop, some HELOC lenders will reduce the amount of credit available; under severe circumstance they may terminate the line. Additionally, if your home value drops below your HELOC balance combined with a first mortgage, you will find yourself underwater. Loans always take precedence over equity. When you use your home as collateral, it’s at risk if home values decline like they did in 2007-20009. If, for any reason, you cannot make your HELOC payments your loan may go into default and your lender may foreclose to get their money back. You may even lose the home.
As you can see, there are several factors to consider when selecting this kind of debt tool. It does not mean that this is not a good way to release liquidity in the home. A HELOC may be right for you, if you want an easy way to borrow sometime in the future when you may need the funds. It is not optimal if the goal is to use the equity in your home for long term improvements, to create a long-lasting stream of income, or to diversify your wealth outside of your home. In the next two posts, we are going to look at the ups and the downs of the other two main alternatives we mentioned in the beginning: home equity loans and reverse mortgages. We will then look at how all these options compare to equity access and hopefully, by then, you will be able to answer the original question: why should I share? Thanks, and see you next week!