This loan type is popular with homeowners — but it comes with a huge risk

If you’re one of many homeowners who need to supplement their monthly income with a little extra cash, a home equity line of credit may seem like the perfect solution. While it’s quite common for homeowners to borrow against the equity in their home, there are some risks.

A home equity line of credit (HELOC) is a revolving line of credit that uses the equity you have in your home to determine the amount of money you can borrow. Unlike a loan, a HELOC allows you to access the available funds as needed for a set period (withdrawal period). You can borrow as much or as little of the funds as you want. Once the withdrawal period ends, you begin repaying the amount borrowed.

You may enjoy the flexibility that a HELOC offers. You would have access to a large sum of cash but only repay what you use, and you don’t pay interest on any money you don’t use.

3 risks of a HELOC

While a home equity line of credit could potentially be a great emergency fund option, there are some significant risks and downsides you should understand before you make your decision.

1. It uses your home as collateral: The most significant risk is that a HELOC uses your home as collateral. That means if you fall behind on your payments and you’re unable to catch up, you could lose your house.
2. The interest rates can change: HELOCs have variable interest rates, which means the interest rate can change when federal interest rates go up. A HELOC will likely have a higher monthly payment than other borrowing options.
3. You could face higher monthly payments: Some HELOC loans allow you to make interest-only payments on the money you borrow during the withdrawal period. While they may seem like a no-brainer initially, you could face a balloon payment or high monthly payments to repay what you borrowed once the withdrawal period ends.

Finally, if you’re not responsible, you could spend a lot more money than you planned or than you can afford.

HOME EQUITY LOAN VS. HELOC: WHICH IS BETTER?

Here's what you can try instead

If you’re in a financial pinch, other options may be better for you. You’ll want to consider your current financial situation to determine which of these three alternatives could be best.

1. Cash-out refinance
2. Personal loans
3. 0% APR credit cards

1. Cash-out-refinance

If you need cash, consider a cash-out refinance. A cash-out refinance allows you to replace your old mortgage with a new loan for more than you previously owed. The additional funds are given to you as cash. You may be able to refinance your loan into a longer-term (lower monthly payment) or even reduce your interest rate at the same time.

HOW DOES A CASH-OUT REFINANCE AFFECT TAXES?

2. Personal loans

Personal loans might be a safer option than a HELOC. Many lenders offer personal loans without collateral so that you won’t put your home or other personal assets at risk. You can opt for a personal loan that allows you to spend the cash as you wish or opt for a specialized option, like a debt consolidation loan.

If you need money quickly, a personal loan might be a better option than a HELOC or cash-out-refinance since lenders can approve funds within a few days.

CAN YOU GET A PERSONAL LOAN WITHOUT A CREDIT CHECK?

3. 0% APR credit cards

If you have good credit, you may qualify for a 0% APR credit card. Many of these cards offer a promotional period of six to 18 months. During that time, you can make purchases and pay off your balance without accruing any interest. If you opt to use one of these cards, read the fine print. Some cards charge deferred interest once the promotional period ends. Additionally, once the promotional period ends, you’ll likely pay a higher interest rate than you would with a HELOC or personal loan.

PROS AND CONS OF BALANCE TRANSFER CARDS

Many people are facing financial difficulties because of coronavirus restrictions and job loss. If you’re struggling to cover your bills or you’d like to set aside a quick emergency fund, one of the above options may be helpful.