Home Equity Lines of Credit or HELOCS are a hot topic of debate these days. Praised as an extremely valuable financial tool by some experts, HELOCs worry other pundits who fear that uninformed consumers will end up putting themselves in even greater debt.

At YOU Magazine, however, we have no interest in furthering this debate. Instead, this article is designed simply to explain what HELOCS are and how they work, including their advantages and disadvantages. Finally, we will offer three scenarios borrowers might commonly face in today's market, and present how HELOCs could affect their short- and long-term financial goals.

What is a HELOC?
Like a traditional mortgage, a HELOC is a line of credit taken out against real estate or available real estate equity. Unlike a traditional mortgage, HELOC borrowers, using special checks or credit cards, are advanced chosen sums up to the maximum withdrawal amount originally approved by the lender. A HELOC is set up over a specific term, which means borrowers have a predetermined draw period (often 5 to 10 years) and repayment period (generally 10 to 20 years). Borrowers are only required to pay interest during the draw period and principle payments during the repayment period.

Advantages
When set up correctly and utilized responsibly, a HELOC can offer a borrower convenience, peace of mind, and support for:

• Lowering down payments
• Remodeling and home improvements
• Paying off high-interest credit cards or other revolving debt
• Paying for college tuition
• Creating liquidity for investment opportunities

When consumers are presented with potential investment opportunities, the timing of the market or possible income tax ramifications may make it unwise to liquidate invested assets. With a HELOC in place, a responsible borrower won't necessarily have to miss out on calculated investment opportunities. A HELOC can also serve as a kind of financial insurance policy against:

• Major financial crisis or loss of income
• Unexpected family emergencies
• PMI premiums

Potential Dangers
The ease of obtaining a HELOC makes it very tempting. But remember, when a borrower opens a home equity line of credit, the transaction does place their home at risk. Home equity lines typically involve variable interest rates based on a publicly available index, which means the interest rate will fluctuate, mirroring the index. To calculate the interest rate that the borrower will pay, most lenders add a margin to the index value. Because the cost of borrowing is tied directly to the index rate, it is important to find out which index and what margin each lender uses, how often the index changes, and how high it has risen in the past. Typically, the index used is the Prime Rate.

Finally, borrowers should also be aware that the lender retains the right to suspend or reduce the line of credit available if any of the following occur:

• The property value falls lower than the appraised value used to originate the loan, and the bank decides it is necessary to re-evaluate the loan.
• The lender believes your ability to repay the loan has changed for the worse (after missing a payment). 
• The borrower defaults on any condition of the agreement.
• The IRS files a tax lien or any other governmental action occurs that might affect the lien position of the loan.
• The loan is paid down to a zero balance.

Now that we've examined the potential benefits and dangers of HELOCs, let's take a closer look at some common HELOC scenarios that borrowers may encounter. 

New Mortgages and Refis:
Home buyers who are putting at least 20% down or homeowners who have at least 20% equity when refinancing should consider taking out a HELOC at the time of closing. In many cases there is no cost to initiate a HELOC. And, should property values fall in the future, the HELOC will already have been secured at the higher appraised value.

HELOC Holders
Over the last three years, many homeowners initiated HELOCs either to minimize their down payment or avoid PMI, which is now tax deductible for new borrowers. These homeowners have seen their interest rate move with each action taken by the Federal Reserve. For many of these borrowers, the dangers now outweigh the benefits of having a HELOC in place, since three years ago it was a much different real estate market. To decrease the overall amount of interest, in some cases significantly, these borrowers should consider refinancing into one new first mortgage.

Considering a HELOC?
For homeowners currently considering a HELOC for major home improvements, starting a new business, or looking to fund another major expense of $50,000 or more, think twice. Many borrowers in this situation will be much better off taking on a new first mortgage and pulling their cash out in one lump sum. Even with a fixed or low interest rate mortgage in place, some borrowers could easily reduce their overall interest payments with one new loan, as opposed to adding a new HELOC to the first mortgage.

A HELOC is not a one-size-fits-all product. And, while it has definite dangers, it can be an extremely value tool if initiated properly and used responsibly. If you've been considering (or avoiding) a HELOC because of the recent flood of media reports, seek the advice of a mortgage professional to determine whether a HELOC could help meet your specific financial needs and goals.