The idea of being able to tap a home equity line of credit at any time has always sounded pretty cool, even sexy. It shows you’ve got your act together, that you’ve planned for any financial emergency, that the bank has got your back.
You may never have to use your “line,” but it’s good to know you’ve got it just in case. It just provides you with another layer of protection and security, which is the same reason you carry a spare tire and road flares in your trunk in the event your car runs over a nail in the middle of the night on a deserted highway. A line of credit can be that one tool that puts you back on the road to financial recovery.
You know that if you live long enough, that emergency is going to come. Maybe you’ll need emergency dental implants after a wild throw knocked out your two front teeth at your company’s annual softball game. Perhaps, you have to cover your daughter’s first tuition payment at MIT. (Why didn’t she agree to go city college for the first two years?)
But like any emergency measure, you have to know when to use it and apply it. I mean, as much as that spare tire might have saved you, you don’t keep driving around on spare tires. You use it for a defined period of time or with an exact plan in mind, then you move on.
So, what would be a good scenario for using a HELOC (pronounced HEE-LOCK)? Well, let’s take one step back first and describe exactly what it is.
The ABCs of a HELOC
A HELOC is set up as a line of credit for some maximum draw, rather than for a fixed dollar amount. For instance, if you take out a standard mortgage, refinance or home equity loan for $100,000, you receive the full amount at closing. With a HELOC, you receive the lender’s promise to advance you up to $100,000 in an amount and at a time of your choosing. You can draw against the promised amount using a special credit card, debit card, check or other means your HELOC lender might have set up for you.
But even better than using a super-charged credit card, you get to write off the interest on your taxes (on balances up to $100,000) with a HELOC. You can’t do that with credit cards. Upfront costs for HELOCs also are relatively low.
A popular product with homeowners before the 2008 real estate crash, precipitated by among other things like people using their homes as their personal piggy banks, the HELOC seems to be back in vogue. Available credit extended via HELOCs to U.S. homeowners jumped 27 percent to $120 billion in the 12 months ended June 30, 2014, according to Experian Decision Analytics data.
Although HELOCS have some clear advantages, don’t assume you’ll automatically qualify for one. You’ll need to meet your lender’s standard for income and credit quality, and, of course, you’ll need that all-important home equity — that positive difference between what your home is now worth and what you owe on your current mortgage.
“Never forget that the ‘E’ in HELOC stands for equity,” said lender Kent Sorgenfrey, with Irvine, Calif. mortgage lender, New American Funding.
Provided you meet the criteria, you now need to know some of the HELOC’s disadvantages. Even if you roll on three good tires, one bad or bald tire could throw you into the ditch financially.
A HELOC’s disadvantages
The biggest caution sign has to do with the HELOC’s interest rate. It’s variable, meaning the rate can go up and down daily like a rollercoaster. So, a HELOC is essentially an adjustable rate mortgage (ARM), but most ARMs at least have caps limiting the size of any rate change. Most HELOCs have no adjustment caps.
As for a little rate history, HELOCs are tied to the prime rate. In the three years prior to June 29, 2006, the prime rate changed 17 times. In 1980, it changed 38 times, ranging between (close your eyes) 11.25 percent and 20 percent!
Today, however, is a far different rate environment.
“The good news about a HELOC today,” Sorgenfrey said, “is that rates are extremely low.” If you are interested in a HELOC, visit our rates page to compare the best rates.
Whatever is borrowed, of course, must be paid back. Typically, a HELOC may have a minimum monthly payment requirement (often interest only). This doesn’t preclude the borrower from making a repayment of any amount so long as it is greater than the minimum payment but less than the total outstanding.
“As the borrower pays down any principle on an interest-only loan, it automatically reduces the required interest-only payment, so it gives the borrower control,” Sorgenfrey explained.
Usually, the borrower pays interest only on the balance for the first 10 years — this is usually the draw period — before being faced with paying off the full loan (principal and interest) at whatever the current interest rate is at the time. The full principal amount could be due at the end of the 10-year draw period, either as a lump sum balloon payment or according to an amortization schedule extending another five, 10 or more years.
HELOC rolls back the odometer
Now let’s discuss our hypothetical HELOC candidate, a 65-year-old modest income earner who will have to rely on $1,000 a month in Social Security after she retires to help pay her monthly mortgage of $400 on her $200,000 home on which she still owes $40,000. With minimal retirement savings, she’s in a tight box.
She has options, however.
1. She could live like a hermit and starve herself, and when she finally pays off the mortgage, her heirs will bless her for their inheritance.
2. She could seek a reverse mortgage, but unlike HELOCs, loan expenses are very high.
3. She could apply for a HELOC (while she’s still gainfully employed) and use the proceeds to pay off her mortgage. In turn, her interest-only payments for the next 10 years will be about $100 a month, not the $400 a month. At the end of the 10 years, she can sell the house, repay the relatively small balance or choose a reverse mortgage.
The point is, her HELOC has bought her precious time during a personal financial crisis. Her stop sign is only temporary. She can move ahead at a new pace.
Of course, there’s a cost (lower gas mileage) to carry that spare tire. But it’s good to know it’s there when you need it.