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…
I did take out a HELOC once, in order to be able to refinance my house out of my ex-husband’s name, but I would not do for other reasons. (And looking back, I’d probably have been better off not doing so at the time and just moving to a smaller house instead.) I am very debt-averse, and don’t think it’s worth the risk.
Jackie, a HELOC is definitely not for everyone, that is for sure.
One of my main thoughts though is that I would rather have low-interest debt that is tax-deductible vs. credit card debt.
No I haven’t, but we talked a few times about establishing one, just for emergencies purposes or for purchasing a car…
Sounds like you have a great Money Hack going on there Kris!
I don’t think I’ll get one any time soon, but it is a great idea!
Nice work! It’s great to see that you were are able to be a positive example for taking advantage of housing based credit. I know that lending is still very tight but you have just shown everyone that it’s not impossible. Leaving it open is a very smart move as well – now you have a little flexibility and a safety net should you need it..especially if something really fun comes along. I can remember having clients who used this kind of credit to make bets in financial markets against my advice. Some won which was great for them and a few didn’t which set their plans back about 5 years.
Money Reasons – I am going to show my ignorance here, but what is a Money Hack? Not sure if I should take it as a compliment or be offended!
Nunzio B – I also remember people taking out home equity loans to put the money in the ever growing stock market. I am sure many of those homes are now foreclosed or under water. I love my HELOC. Costs me nothing, and gives me security.
The rates on HELOCs are very low now, so I would definitely recommend applying for one. We have one and I applied for it because the rate was low (PRIME-.5%), it had no fees at all except a $30 annual fee to maintain, and the interest is tax-deductible.
I know I would not use the credit as leverage for playing the stock market in this economy, though.
One thing to be very careful of is the possible change in the interest rate (since lines of credit typically come w/a variable rate), and the timeline you are given to pay back any loan, some HELOCs give you 10 years to borrow and 10 years to repay…some have a balloon payment where you have to pay back all
Also, the lenders can do some outrageous things, for example, with this economic crisis, some banks have decided to withdraw lines of credit without warning, leaving homeowners holding the bag after they had already hired the contractors and had the kitchen remodeled, forcing them to rely on credit cards!
Yes, I did take out a HELOC to cover the costs of renovating the house my son & I copurchased…the HELOC, of course, turned out to be every bit as much a losing proposition as the underwater house. 8-o
When it became evident that the university would soon lay off me and all my staff, I took on an extra job so as to pay that loan off while I still had an income.
One of the things I learned about that particular variable-rate loan, BTW, was that the cap I imagined existed — around 8% — did not exist at all! In a conversation with a CSR, I learned the interest rate on the darn thing could have gone as high as 21 percent!!!
@Everyday Tips
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Sorry I’m so late on this. A money hack is a way to save money by using an unconventional trick or method (or at least that’s the way I use the term
My husband and I have a HELOC and LOVE having the security of it being there. We are extremely disciplined so we never touch it (really just an emergency low interest line available to us in our minds). Interest rates are low so it is a great resource for “cheap money” should we need it for an unforeseen purchase. Also thinking about a new car in a year or 2 and the rate will probably be better than a car loan so can use it for that. Bottom line…. for us it offers peace of mind and an added level of low interest security and we echo your thoughts on it as outlined in your well-articulated writeup here above!!
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