HELOC Disadvantages

Home equity lines of credit, or HELOCs, are often considered to be a good option for those who need to take cash from the equity they have built in their home. The revolving nature of the loan is perfect for those with intermittent financial needs, especially when these needs are not completely predictable.

However, HELOCs have some significant disadvantages that should be discussed as well. One of the primary differences between a HELOC and other adjustable rate mortgages (ARMs) is the fact that interest is calculated daily. This is necessary because the loan’s balance may also change from day to day. However, the daily interest calculation also makes monthly payments less stable than for traditional loans.

The primary disadvantage to HELOCs is the increased risk from rising interest rates. All HELOCs are adjustable rate, but they carry a higher risk than standard ARMs. Market changes affect HELOCs very quickly.

If rates rise on July 31, your HELOC will reflect the change on August 1. Some HELOCs do have guaranteed initial rates, but they are always for a very short period of a few months. Many standard ARMs, on the other hand, have a fixed rate for as many as five or ten years.

There is another big difference between HELOCs and standard ARMs that increase the risk associated with HELOCs. HELOCs do not have the same type of adjustment caps that most ARMs do.

This allows rates on a HELOC to rise drastically if this is what the market demands. ARMs also have a much lower maximum rate than HELOCs, usually only five or six percent higher than the initial rate. HELOCs, on the other hand, have a high maximum rate of 18 percent.

Another HELOC disadvantage is the difficulty of comparing the rate with other loans. Annual percentage rate (APR) for HELOCs does not include points or upfront costs, as APR for other loans do. The requirement to disclose the APR for a HELOC basically amounts only to a two-time mandatory disclosure of the regular rate.

Despite these disadvantages, HELOCs can be a sound choice for many borrowers. However, it is important to be aware of the risks associated with these credit lines before committing to them.