The way a home equity line of credit works is simple. You apply for a loan in the normal manner. You put up real estate as collateral security (give a mortgage on your home). Once you are approved for the line of credit, you have access to any or all of the money up to the loan limit.
A line of credit gives you the advantage of having money available interest-free, and only borrowing the exact amount you need when you need it.
Your interest rate will be adjustable, unless the term is short. You will not be offered a fixed rate on a thirty-year loan, for example, since you could simply wait for rates to go up and then borrow at the fixed lower rate. Some lenders allow you to convert to a fixed rate loan once the line has been used. If you wrote a check against your adjustable rate line of credit for $100,000, you could convert that amount to a fixed rate loan. Since you have already qualified, there are usually small or no fees charged. This would be beneficial if you wrote the check expecting to repay the loan quickly and now must keep it for a longer time. Not only will your interest rate be adjustable, but the cap (maximum interest rate) will also most likely be very high, especially if the term is twenty or thirty years. Most adjustable loans will have a cap of about 5%. If you borrow at 5% interest, for example, you will never have to pay more than 10%, regardless of the market interest rate. With a line of credit, your cap on a 5% loan could be 15% percent or more, bringing the highest rate you could pay to 20% percent or higher.
The reason that the line of credit has a higher cap is because it is revolving. This means that you can borrow, pay it back, and then borrow again. This will go on for the life of the loan, which could be as long as thirty years. It is really a credit card with your home used as security. The difference is in the amount of money available. A credit card will usually have a maximum amount that can be borrowed in the thousands, sometimes tens of thousands for strong borrowers. The equity line of credit can be in the hundreds of thousands. It is easy to see the financial difficulty an equity line of credit can create.
Equity lines are almost always tied to leading indexes, and the rate can rise rapidly.
Example: You owe $10,000 on your credit card at 10% interest. Your interest amount is $1,000 per year. Interest rates rise to 20%, as they did in the 1980s. Your interest amount is now $2,000 per year. With some wise budgeting, you can probably pay the interest plus something on the principal. In a few years you can pay off the debt. You owe $200,000 on an equity line of credit at 5%. Your yearly interest is $10,000. Interest rates go to 20%. Your yearly interest is now $40,000. Even with careful budgeting, most borrowers have difficulty making the interest payment, let alone reducing the principal. The problem is that you do not need to be wealthy to get an equity line in the six figure range. Anyone with good credit and an ordinary job can get that much or more if there is sufficient equity in the home.
Once interest rates rise substantially, there are other problems. High interest usually means falling property prices. In those situations, the equity you borrowed against may shrink, and it may be more difficult to sell or refinance the property to pay back the loan. If the debt becomes unmanageable and you cannot sell the property to pay it off, you are left in foreclosure or bankruptcy.