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We have a question from Danielle.
And she says I owe money on a very low rate Home Equity Line
Of Credit, also known as a HELOC, and I've been making
only the minimum payments since taking it out
several years ago.
So she wants to know, is paying the minimum on a HELOC
a good idea?
Wow Danielle, you've hit on what I think is a huge and
potentially dangerous financial issue that very few
people seem to be talking about.
So I thank you for asking this question.
My biggest concern with what you and many others are doing
here is that you may be setting yourself up for some
big problems in the future.
As I see it, there are two big risks associated with paying
only the interest or the minimum on a home
equity line of credit.
They are, one, potentially rising interest rates and,
two, balloon payments owed at the end of the draw period.
Rising rates are a potential problem because most of the
HELOCs out there have a variable interest rate
associated with them.
This means if interest rates increase, so will the required
minimum payments.
For instance, if rates double then, directionally speaking,
the minimum payments will as well.
With many people out there thinking that rates are poised
to rise in the near future, this could create some serious
cash flow problems for people making
only the minimum payments.
So now let's look at the potential problem associated
with the balloon payments.
This is a potentially serious issue because, by definition,
they require the HELOC balance to be paid back.
Here's what I mean.
Home equity lines of credit have what is known as a draw
period during which the borrower can usually draw and
pay on the line as often they which, of course paying
interest on any outstanding balances each
month along the way.
Depending on the lender, and the product chosen, this draw
period typically ranges from 5 years to 20 years in length.
Where the potential problem happens is that at the end of
the draw period any outstanding balance, the
balloon payment, has to be repaid.
Some HELOCs automatically convert the balloon amount to
a fixed period loan at that point, but some actually
demand the full amount be paid all at once, meaning the
borrower either has to come up with the funds to pay it off
or refinance it into another loan.
Unfortunately, some people aren't going to have the funds
available at that point, or they
won't qualify to refinance.
And that's not a good situation by any definition.
So Danielle, to drive this point home, let's look at some
numbers to help you decide if your minimum payment strategy
is a good one or not.
Let's start by assuming that somebody has taken out a
$75,000 home equity line, and it has variable
interest rate of 4.5%.
Assuming an interest only payments strategy, the payment
would be roughly to $281 a month, as you see here.
But what if interest rates go up?
Well, at 6% you can see the payment it would be
approximately $375 a month.
And at 7%, it would be approximately $500 per month.
So as you can see here, rising interest rates can be a big
deal if you're only making the minimum payment.
Now let's look at the balloon payment
risk I mentioned earlier.
For this example, let's assume of the line of credit we were
using automatically converts to a 15 year loan at the end
of the draw period.
If the interest rate of that loan at the time is, let's
say, 7%, then the monthly payment will be approximately
$674 per month.
At 8% it would have been $717, and at 9% it would be about
$760 a month.
Compare this to the original payment that we had of $281 a
month, and we're talking about a payment that's slightly more
than 2 and 1/2 times larger than where we started.
As these numbers clearly illustrate, the payments on
these products can go up considerably, either due to
the rising interest rate, the balloon payment amortization,
or both, and the borrower is essentially
powerless to stop it.
So what's the bottom line here?
The bottom line is, even though you may have low
payments now by just paying the interest, I'm afraid that
may come back to bite you later on down the line.
To avoid that and maintain control of your finances, I
think, Danielle, you should come up with a strategy today
to proactively address this rather than wait and be forced
to deal with it later on down the line.
If your line of credit is with USAA, please give us a call,
and we can help you with this.
You can reach one of our lending specialists by calling
the number on the screen.
It's 800-531-9189.
Thanks again for your question, Danielle, and for
giving me the opportunity to weigh in on what I think is
going to be a big issue for a lot of people.
I wish you all the best.