In my last post about HELOC's for physician families, I mentioned the advantages a home equity line of credit. Today I'll tell you the one thing you need to know about a HELOC that will make you a smarter borrower. A home equity line of credit is a credit product that works almost exactly like a credit card.
- It's flexible. When you need money, you can borrow it, and most HELOC's allow you to borrow at any time in any amount up to your limit, just like a credit card.
- It's variable. Your payments will go up and down depending on the prevailing interest rates because interest rates on home equity lines of credit are variable rates based on some "benchmark" like the prime rate or the rate on the 1-year US Treasury note, just like a credit card.
I say that it's almost exactly like a credit card because there's one MAJOR DIFFERENCE between a home equity line of credit and a credit card.
If you don't make the payments on your home equity line of credit, the bank will take your house away.
You see, a regular credit card is what financial advisors call "unsecured credit," meaning that the creditor has little recourse other than to thrash your credit report if you fail to pay. But a HELOC is "secured," meaning that the bank will place a lien against the equity in your home on the day your HELOC becomes effective. Hence the word "equity" in home equity line of credit.
This lien works just like the lien that goes with your first mortgage: if you fail to pay, the bank can take action to gain repayment of the HELOC, and one action is foreclosure. And that's why the rate on a HELOC is so much lower than the rates on unsecured credit cards. The bank knows they'll get their money back, one way or another.