The following is a guest post from Kris at Everyday Tips and Thoughts. She brought up HELOCs once and I just had to know the details.  If you enjoy this, you may also like her posts, Lawn Care-Tips for a Healthy Lawn, How Much House Do You Really Need? , or Tips for Traveling With Kids.

HELOC Description

Have you ever wondered exactly what a Home Equity Line Of Credit (HELOC) is? It is a loan taken out from a bank or credit union that works more like a line of credit. You don’t have to borrow the maximum amount you qualify for, you can just draw out money as you need it, up to the predetermined maximum amount. Often times, the rate is variable, and there may be different payment options available.

For instance, our HELOC has an ‘interest only’ feature, which requires just the interest payment be paid every month. Of course, I never advise paying only the interest. It can be difficult to be approved for a HELOC these days because home values have dropped so much. The bank requires the property be used as collateral, so if there isn’t much equity, there won’t be much loan, if any at all.

However, if you can get approved for a HELOC, and you have some self-discipline, it can be a wonderful thing.

How to Qualify

We took out a HELOC to do some remodeling around the house. Our kitchen desperately needed an upgrade, along with a few other things. So, we pursued a HELOC through our credit union.
When I called our credit union to discuss a HELOC, I was told that they had not approved anyone in awhile. I knew things were bad, but I didn’t know it was that bad. The reason being, you must always maintain at least 20 percent equity in your home. (There are other requirements too, like employment, credit score, where you live, etc.)

To see how much you would qualify for, look at the following example:

Lets say you bought your house for $130,000 and have a remaining principal amount of $80,000. However, your house is now worth $100,000. You would not qualify for a loan at all, even though you have paid off $50,000 from your principal. ($100,000 x .80 = $80,000. $80,000 – $80,000 = 0).

On the flip side, you can see how people got into financial trouble when times were good and homes were priced much higher than the purchase price. Taking the previous example, lets say that house is now worth $160,000. You would now qualify for a loan amount of $48,000. ($160,000 x .80 = $128,000. $128,000 – $80,000 = $48,000). So, if you fully use the entire loan, you now owe $128,000 between your mortgage and the HELOC. If the market then free-falls as it has recently, you may be in some financial trouble, especially given pay decreases and job losses. If you are forced to move, it may be difficult to see selling that house for $100,000 when you owe $128,000.

Our HELOC Example

We took out a loan for $35,000. There was not any application fee and we had paid down enough of our mortgage to not require an appraisal, so the whole process was free. We used the full HELOC amount of $35,000 and paid it off in 6 months. Even though the loan is paid off, we are not closing out the loan. Why you may ask? Because I like the security that the HELOC provides.

Even with the variable rate of prime plus 0.5%, it is way better than any rate I can get on a credit card. The $35,000 just sits in the loan bucket of my bank account, and I can move money back and forth any time I want. So, let’s say I have to go buy a new washer for some reason and I don’t have easily accessible money. I can charge it, get my rewards points, and then transfer $800 or whatever the cost of the washer is from my loan account to my checking account when the credit card bill is due. I can then transfer from my checking account into my loan account when I want to pay it off- all electronically and from the comfort of my own home.

Another benefit is that the interest is tax-deductible. Therefore, it may be attractive to use your HELOC to make big purchases. For instance, if you want to buy a used car for $10,000, and the interest rate on a car loan is high, you could pay for the car in cash from your HELOC and then work toward paying off the amount borrowed. Or, you can pay off your credit cards using your HELOC, which most likely has a way lower interest rate than your credit card. If your HELOC is used for this purpose, I also suggest cutting up those credit cards if there is any chance at all that you are going to charge them up again.

Overall, with the prime rate being as low as it is, a HELOC is a great way to reduce the amount of interest you would pay if you cannot meet your monthly obligations. Ideally, you wouldn’t ever need additional money to pay your expenses, but that isn’t always the case for everybody.

Additionally, a HELOC can be a wonderful safety net, if it is used properly. You MUST be disciplined enough to see it ONLY as a safety net, and not the chance to buy a bunch of cool stuff.

I cannot tell you how much I like knowing that money is there in case I need it. Sure I have some other savings put aside in case of emergencies, but having easy access to this money provides peace of mind. However, terms and conditions on HELOCs vary greatly, so do a lot of research before entering into any loan agreement. If the economy changes and interest rates start to increase dramatically, a HELOC may not be such a great idea anymore.

Crystal’s Questions and Comment:
Have you opened a HELOC? If so, how did it work out? If not, would you consider it?

I’m thinking about it just so we’d have a backup emergency fund in case my car gives out before I can afford to pay for my next one in cash…