Use Home Equity Line of Credit (HELOC) Wisely

Are you a homeowner?  If yes, probably you noticed that, the value of your home went up lately.  Today we are going to tackle the details of the Home Equity Line of Credit, abbreviated as HELOC. Sometimes it’s simply called ELOC.

Knowledge is power.  Next time, when you are in the bank, the banker may want to drag you to his/her office with all smiles, and try to sell you HELOC.  You’ll know what questions to ask.  And you’ll be more confident to make a decision that is good for you, and your family.

What is the Home Equity?

To understand the Home Equity, let’s look at two things first:

  • What is the current market value of your house? (abbreviated as Market Value)
  • What is the current balance of all the loans you borrowed against your house? (abbreviated as Loans)

Home Equity is the difference of the Market Value and Loans:  Home Equity = Market Value – Loans

The Market Value varies depending on what source you use.  The county auditor’s web site gives one number, which is used to figure out your property tax.  Other web sites (like Realtor.com, Trulia, and Zillow) provide a little bit different estimates.

Loans include your first mortgage, second mortgage, and any liens that are placed against your house.

If the Market Value goes up, or the Loans come down, the Home Equity goes up.

There are three ways to tap the Home Equity:

  • One is to refinance your mortgage, and take the allowed equity out as a lump sum.
  • Two is to keep the primary mortgage intact, get the second mortgage, and take the equity out as a lump sum.
  • Three is to get the HELOC, which is more flexible. You don’t have to withdraw the fund if you don’t need it right away.

For the first two, you take the lump sum at the closing of the mortgage.  At that time, you have probably planned out how to use the money very soon, like a big home renovation.

What is HELOC?

HELOC is a line of credit borrowed against your house equity.  You don’t pay interest if the balance is zero.  It comes with a check book.  Anytime you need to withdraw the money, just write a check to yourself.  It’s handy.

HELOC has a credit limit.  That’s the maximum amount you can borrow.  It’s specified in the loan document, together with the rate, term, fees, etc.

Read the details of each page of the HELOC document.  If you don’t know about the terms, just ask.  Don’t count on others reading it for you.  Read it yourself, please.  Don’t sign it blindly, as it will hurt you later.

Loan to Value ratio:

Here comes the concept of Loan to Value ratio.  It is in percentage:  Loan to Value ratio = Total amount of loans / Market Value

The total amount of loans include your existing loans (mortgages and other liens), plus the HELOC credit limit.

Many banks allow you to tap only part of the home equity.  In another word, they try to keep the Loan to Value ratio to 80% or lower.  Some banks might offer a higher ratio like 85% or even 90%.

HELOC interest rate is related to your credit score, debts, and income, of course.  It’s also related to the Loan to Value ratio.  The higher the Loan to Value ratio, the higher interest rate your HELOC will be.

Here is an example:

Let’s assume:  the Market Value of your house is $100K.  The balance of your primary mortgage is $50K.  There is no second mortgage or liens.

If you go for the Loan to Value ratio 80%, your HELOC credit limit will be $30K:  ($100K x 80%) – $50K = $30K

If you go for the Loan to Value ratio 90%, your HELOC credit limit will be $40K:  ($100K x 90%) – $50K = $40K

HELOC has Variable Rate:

Keep in mind that, HELOC has a variable rate.  The interest rate is not fixed.  It’s tied to the bank’s prime rate.  Your interest rate could be 1%, 2%, 3% plus the prime rate, and is specified on your loan document.  The prime rate is affected by the Federal Reserve’s rate.  It changes over time, and is beyond our control.  Currently the prime rate is 4.5%.  If the Federal Reserve raises the interest rate, your HELOC rate will rise accordingly.

HELOC’s Monthly payment and balloon payment at the end:

The more the HELOC balance you have, the more you have to pay each month.  In many cases, the minimum payment is mainly to cover the interests.  But, as the end of the loan term, usually 10 years, you’ll have to make the balloon payment to pay off the remaining balance.  Get prepared if your term is close to the end.

HELOC has Fees:

Always ask the bankers about the fees at the front.  Here are two examples.

HELOC has annual fee, even if your balance is zero.  For the first year, the annual fee is usually waived.  It is less than $100 in most of the cases.  Some banks could waive the annual fee for the 2nd year and beyond, if you have some relationship accounts with them.  Ask them how, and see it’s worth it.

Also watch the early closing fee.  Many banks require you to keep the HELOC open for a certain number of years.  You balance can be zero.  If you close it too early, a penalty will be applied.

Tax:

Under the new federal tax law, the interest paid on HELOC is no longer tax deductible.  This change affects those people who itemize their tax returns.

This should give you a good picture of what HELOC is about.

What questions should you ask a banker, when shopping about HELOC?  Talk to your family, and write down the list of questions.  Ask them about fees (any application fee, any loan closing fee, annual fee, early closing fee, etc), what interest rate you can get, Loan to Value ratio, the loan term is 10 years or 15 years, how your monthly payment is calculated, etc.

Signing for HELOC is a huge deal, as you are borrowing against your roof.  You got to use it wisely and responsibly.  If you are not that 100% sure if you can do it, just don’t sign up.

Here are some questions you might have:

Should I use HELOC for vacations?

No, absolutely not.  Vacation is not necessity.  HELOC is serious debt.  It’s a secured loan.  If you miss the payment, there is chance you could lose your home.  Home is more important than a vacation, I feel.

Should I use HELOC to pay off the credit card debts?

That’s like robbing Peter to pay Paul.  The answer is no.  To tackle the credit card debts, first is to find out what the problem is.  If you have the spending problem, get that fixed first.  HELOC is not a solution.  It puts your house at risk, and makes your debt situation even worse.

Credit card debt is unsecured loan.  If payment is not made, the creditor could not take your home away.  But HELOC is a completely different animal.  You need a home.

Should I use HELOC to buy a car?

No.  Use cash to buy a car if you could.  If you can’t afford a new car, buy a used one.  Don’t use HELOC, as you are betting your roof.  If you have to borrow money, try to get a car loan.  Car loan usually has a fixed interest rate.

Should I use HELOC to pay for kids’ college expenses?

No, I don’t think it’s a good idea.  With HELOC, the debt burden is on you, no matter what.  Kids probably have to get student loans, and work part-time if needed.

Should I use HELOC as the Emergency Fund?

Yes, only if you could use the money very consciously:  use it only when there is a real emergency.  Make sure you have the means to pay back shortly.  Buying furniture or TV is not an emergency.

If you have a hard time controlling the spending, don’t use HELOC.  Try to squeeze your monthly expenses, and save money for your emergency fund.

Should I use HELOC for home renovations?

Yes, only if you can afford it.  And the renovations add good value to your house.  I know this is a gray area.  Sometimes thousands of dollars are put into the house.  When the house is sold, you won’t get all the money back.

In summary, it’s sweet to see your home equity keeps growing.  Tapping the home equity is a huge family decision, and you should take a lot of caution.  Use the HELOC wisely.  Keep in mind that, the house value could go up, and could go down as well.  During the 2007-2008 financial crisis, many houses were under water, and the homeowners were stuck there for years.  That was tough.

Questions to you:  have you ever used HELOC?  If yes, what did you use it for?

Take a look at my eBook, a mini-memoir on Amazon: “DAD’S BICYCLE: Journey of A Chinese Family”.

12 Responses

  1. Joe says:

    I’ve never used HELOC and didn’t really know much about it. I thought you can deduct the interest. If not, then there doesn’t seem to be a point for it.
    It sounds like a good place for the emergency fund, but could be a slippery slope too. I’ll probably continue to avoid it. Why not just refinance to get the money out instead? That’s not good either…

    • Retire Early Helen says:

      Joe,
      You are right, the HELOC interests used to be tax deductible. Not any more after the new federal tax law in late 2017. It’s flexible, you can choose to withdraw it only when needed. Then pay back, and withdraw again. Yeah, it could become a slippery slope if people can’t control the spending.

  2. Bob says:

    We’ve had a home equity line of credit for about 15 years, that’s what they called it when we got it. The interest rate has always been variable but only around 4%. We’ve only used it a couple times for a short time period and I can’t even remember what for I always thought it would be nice to use for another market meltdown like 2008 and only if stocks went down at least 40% or more and then only use a small portion of the available amount so we couldn’t get into trouble. But I never used it in 2008 because I thought that was different and didn’t want to risk it. May not be another chance like that for 15 years or more.

    • Retire Early Helen says:

      I used the home equity line of credit for 4-5 years in the early 2000. It was handy as an emergency fund cushion. The rate was 1% above the prime rate, not too bad. Yeah, the risks are there, for sure.

  3. Steve says:

    Hi Helen, I used my HELOC in 2009 and bought stocks but since I have paid it off . My HELOC does not have any fees if you are not using it, so I now have it as an emergency fund

    • Retire Early Helen says:

      Steve,
      2009 was definitely a good year to buy stocks, very nice call. I was too scared then, and didn’t invest more (I should). I bought a car in the early 2009, and got a little bit tax benefit. For the amount of sales tax paid, I didn’t have to pay the federal tax. That’s the one-time stimulus by the government. Yeah, HELOC could be a good cushion for emergency fund.

  4. GYM says:

    Great post explaining the HELOC! In Canada you can deduct the interest on the HELOC if you use it to invest (otherwise you can’t deduct any mortgage interest off your primary residence). I have a HELOC but I have never touched it. I might be using it soon for investment purposes.

    • Retire Early Helen says:

      It’s interesting the tax rule is so different. So, in Canada, I guess the government encourages investing. In US, the federal tax rules changed quite a lot in December 2017, and HELOC interests are not tax deductible any more.

  5. Caroline says:

    My HELOC is my emergency backup. I just couldn’t leave my money in a regular savings account!
    I have used my HELOC for real estate investing a few times so far:)

    • Retire Early Helen says:

      Caroline,
      That’s cool you used HELOC for emergency backup and real estate investing. The interest rates of saving accounts have been so low, and lasted for ridiculously long (10 years). People really don’t feel motivated in putting money into savings accounts.

  6. Thank you for sharing information about HELOC. Your introduction is very detailed, and maybe I will need this information in the future. I have to have a house of my own first.

    • Retire Early Helen says:

      Paul,
      HELOC could be very useful if used properly. I would be very glad if this post could help you and other readers in any small way. Thank you for stopping by. Have a great day.
      – Helen

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