A home equity line of credit is popular, but is it smart? Learn how to get the cash you need while keeping your home and finances safe and sound.
A Home Equity Line of Credit, or HELOC (pronounced hee-lock) as it is called in my industry, has become as common as SUVs and Starbucks. If you don't have one, I bet you know someone who does. People use HELOCs as an easy way to get lots of cash.
A HELOC, technically, is an Open Ended Deed of Trust, which is a credit line secured against real property, typically a home. HELOCs have a credit limit based on the value of the property used as collateral.
Like other credit lines, a HELOC allows borrowing money up to a pre-set limit. The borrower is billed for the amount borrowed, and can pay back or draw out more at any time. Think of it as a credit card secured by the property.
Once you have the line of credit, the money is easy to get. HEOLOC lenders usually issue checkbooks, ATM cards and credit cards to pull out funds. If you have a $100,000 HELOC with a zero balance, you could write yourself a check for $100,000, go the bank and cash it, walk around all day with $100,000 in a suitcase (consider handcuffing it to your wrist), then deposit it back in the bank the next day and pay down the HELOC balance to zero. When you get your statement at the end of the month, it would show you used $100,000 for one day and you would owe one day's interest for the privilege of using that money.
You can see a HELOC is a flexible tool and can be helpful if used properly. In comparison, a traditional second trust deed, or "closed end loan" behaves just like your first trust deed -- the lender hands you the money at the beginning of the loan and you pay it back at a specified rate over time. You can't draw out the money once you've paid it back. Traditional second trust deeds have advantages over HELOCs in some circumstances, but they are completely different tools for different situations.
Just about every financial institution offers Home Equity Lines of Credit. They all work about the same, but a few are better. Banks vary the terms of HELOCs to attract customers. The variables to compare are the application costs, overall interest rate, annual fee, terms of repayment, early closure fee, and options to lock in the rate later. To be more attractive, a bank might offer a teaser rate, or no costs or fees. It's important to look at everything before signing up.
For example, I had a HELOC on my house through a major national bank, and they called and said if I raised my limit, I'd get Prime Rate minus 1 percent for the life of the loan. Well, that's a pretty good interest rate -- in fact, I've never seen anything better, so I took the bait and signed the documents. The annual fee is $90 per year, which, I now realize, is about $50 higher than I could have gotten at another bank and $90 higher than the annual fee at some credit unions. I keep a zero balance on my HELOC most of the time, so I am not realizing the benefit of the lower interest rate. Every year, I pay the $90 fee for the right to spend $200,000 at the blink of an eye. Of course, if I do run up a balance, I'll benefit from the lower interest, so the $90 fee will make more sense.
Check your rates
Almost all HELOCS are adjustable-rate loans, adjusting the interest rate whenever their underlying index moves.
Most HELOCS are based on Prime Rate as published in the Wall Street Journal
. The rate is calculated by adding Prime plus or minus a "margin" that determines the actual rate you are charged. There are other indexes, and occasionally someone offers a fixed rate HELOC, but they are too rare to discuss here. In most circumstances, the interest paid on a HELOC is tax deductible.
The most important part of a HELOC is the margin. Try to get the lowest possible margin the bank offers. The margin, which controls your interest rate, is based on a combination of the loan-to-value (the total debt on the house compared to the value of the house), the loan balance, your credit score, and your debt to income ratio or income documentation requirements. Margins can go as high as 4.75 percent for high loan-to-value loans, low credit scores, or rental property.
Doing the math, if Prime Rate is 8.25 percent (in 2007, not the same now but the concepts still apply), and you found a HELOC at Prime minus 1 percent margin, your rate would be 7.25 percent, as long as Prime is at 8.25 percent.
Since the balance borrowed and interest rate can change daily, the interest amount you owe is also calculated daily. Multiply the balance by the rate and divide by 12 for a monthly payment or by 360 for a daily charge. Using my loan as an example, to carry $100,000 around in my briefcase all day would cost me $20.14. Cheap thrills! (100000 x .0725 / 360 = 20.14) If I keep the money for a month it will cost me $604.17. Honey, have you seen my briefcase?
All HELOCs require you to pay the interest that's due on the loan each month. On small balances, some require a minimum payment higher than the interest due -- the extra is applied to pay down the borrowed amount. For instance, if I go out and buy a $8,000 Jacuzzi system, the interest due will be $48.33 per month. However, my HELOC specifies that the minimum payment on any balance is at least $100. That’s a very common feature and I don't mind paying the balance down. That's what I should be doing anyway.
However, there are some HELOCs that demand a payment of 1 percent of the loan balance every month. If I run up a balance of $100,000, my payment will be $1,000.00 per month. That payment includes $400 principle, but it makes for a steeper payment than interest only.
Most HELOCs allow you to access the balance and draw out money for about 10 years, then the line freezes and you have 20 years to pay back the balance. Some loans allow you to lock in a certain portion of the balance after you have drawn it out so the rates won’t go up. This is a relatively new feature, and it's very cool.
HELOC in the real world
Whenever anyone asks why I have a HELOC, I tell this story. I have a client who lived next to a widow. When she died, her daughter moved in and began dealing drugs from the house. Conditions went from bad to worse. My client was at his wit's end when the daughter knocked on his door late one night. She was in a hurry to leave, and wanted to know if he would buy the house. How much, he asked? She said it was worth much more, but she felt bad about everything, and if he could give her $100,000 tomorrow and the keys to his truck he could have the house. My client, an attorney, weighed his options and wrote the check. He told me the house was in such poor condition that rats had pulled silverware off the counters and into the walls, where they were shorting out the electricity. But, using his HELOC, he was able to remodel the house and sell it for a tidy profit. The house is now the pride of its new owner.
Jumping on an immediate smart opportunity is the bright side, an example of the proper use of the loan. HELOCs are cheap to obtain, and can be very useful for emergency expenses or anything that requires quick cash. A HELOC is a good idea for remodeling your house, because you can draw out the amount you need as you go, and only pay interest on that amount. A HELOC can be a swing loan between buying and selling property.
Over the last three years, the number of borrowers seeking a Home Equity Line of Credit has risen ten-fold. The Prime Rate was low, credit standards were lax, and banks were literally giving away credit lines. HELOCS were being used to finance cars, vacation homes, remodels, and to consolidate consumer debt.
HELOCs have even used to buy homes. Buyers could finance the home 80 percent with a traditional first trust deed, and then another 10, 15, or even 20 percent with a HELOC. This extends credit beyond the common 80 percent loan-to-value.
But there is a dark side too. HELOCs are not good long term loans. Prime rate can be volatile, which is scary in a rising interest rate market. Borrowers who took out HELOCs a few years ago when Prime was at 4.25 percent watched in horror as it climbed to 8.25 percent by 2007. Someone who borrowed $100,000 watched their interest payment go from $437 a month to $770 a month. Ouch!
And the easy money can be a dangerous temptation for people with poor financial discipline. Some borrowers just took the cash and spent it. But if you cannot pay the loan back, the lender can foreclose on your home.
I've been in the business long enough to remember when Prime Rate was at 18 percent.
Therefore, I strongly advise my clients to use a HELOC for short term financing only. Use it, but pay it off -- just like smart use of a credit card.
I also recommend against borrowing more than 25 to 30 percent of the amount already borrowed on your first trust deed. For example, if you owe $400,000 on your first loan, don't borrow more than $100,000 to 120,000 on a HELOC. If you need more than that, long term, stable financing is a better option.
If you use your HELOC to pay off high interest rate credit cards, that's a good idea -- once. Then hide the credit cards and don't run up the balances again.
Create a payment plan to pay off the HELOC. If you buy a car with your HELOC and only pay the interest due, you will still owe the entire price of the car 10 years from now -- not a sound plan! Too many borrowers use HELOC money to subsidize their lifestyle. Take a hard look at your budget and make sure you are paying off your HELOC balance as fast as possible.
If you got a HELOC a few years ago and are now feeling the pinch of higher interest, call your lender and ask if they will convert all or part of the balance to a lower fixed rate, or if they will lower your margin. Some will do it over the phone to keep from losing your business.
If your current HELOC lender won't improve your terms, call your loan officer or banker and see if refinancing the HELOC is a good idea. This is usually inexpensive to do and might save you a few bucks overall.
Or, it might make sense to refinance your home's first trust deed to payback a high-rate HELOC. Any qualified loan officer can help you decide.
And, be sure to use your own cash effectively. Don't let money sit in the bank where it's earning 1 percent or 2 percent while you are paying much higher on your HELOC. Remember, if you need the money, you can always draw it back out of the HELOC.
If you need a HELOC
Keep your eyes open for good deals on HELOCs -- it's a competitive field. Lenders are constantly refining the terms of their HELOCs to attract new customers, and smart new options are coming out all the time. Some HELOC loans are now hybrids, allowing a portion of the line to be fixed and a portion to remain open and available for draw.
Just be sure to read the fine print, ask a lot of questions, and work with a company you trust. If you do your homework and make the right choices up front, you'll be happy with your HELOC for many years.