A home equity line of credit is taken out against the value of the home minus the mortgage you currently have.
As an example:
House is worth $175,000 and you owe $125,000 on your first mortgage. You have $50,000 in equity in your home. This isn’t to say a bank or mortgage company will lend you up to 100% of the value of the home as many banks only go up to 80%.
Some banks and mortgage companies would lend up to 125% of the value of the house during the first refi boom and lost their butts when people foreclosed. Things have changed in that regards. If you have equity and can find a bank to open a HELOC with than this is why you should get one.
When To Get A HELOC?
I would make the argument as soon as possible.
Did you just buy a house and put a 50% down payment? Call the bank back up and say you want a HELOC up to 80% of the value giving you 30% to have available.
Reason being is you never know when you might need cash fast. If you lost your job than how are you going to get approved on a new HELOC? You won’t.
I’d also make the argument you need to get a HELOC up to the highest amount the bank will give you. Again, you never know. You only pay on what you borrow so if the balance is $0 than you pay nothing.
Need money to pay off debt? Use the HELOC.
Need money for home improvements? Use THE HELOC.
Need money in case of an emergency? Use the HELOC.
Need money to pay for your kids college tuition? Use the HELOC
Need money to buy stocks or flips homes? Use the HELOC.
Since a home equity line of credit is a loan against your house you get to write off the interest that you pay. You don’t get to write it all off but every bit helps.
If you are an investor a HELOC should be considered cash. Tap it any time a great deal comes around. Get out the checks for your HELOC and write a check that day.
Thats the beauty of having a home equity line of credit. Its there when you need it. If you don’t need it then it just sits there waiting for you to use it.
How Do HELOC’s Work?
Adjustable Rate – Interest rates are tied into the Prime Rate controlled by the Federal Reserve. Every time you hear “The Fed is raising (or lowering) rates” your payment will be affected. Some banks offer fixed HELOC’s but they are few and far between. The adjustable interest on the home equity loan is the trade off for the flexibility of the loan.
Interest Only Payments – HELOC payments are based on a 30 year amortization schedule with the first ten years being a interest only period. This means you are only required to make interest payments on the amount you borrowed for the first ten years.
Pay more to bring the principal down when you can which will in turn bring down the required interest only payment. After 10 years the HELOC changes into a 20 year loan where you have to pay down the balance. Don’t like the new loan? Get a new HELOC.
Closing Costs – Are way cheaper than a first lien mortgage. In most cases less than $500. Most banks will not charge you the costs (most of it being an appraisal) as long as you keep the HELOC open for three years.
Fees – Most banks will charge a $50 annual fee to keep a HELOC open.
Depending on where you get your HELOC you will probably be given checks, a debit card, or both. If its with your local bank they will probably give you the ability to transfer funds from the HELOC to your checking account. Makes it easier this way to track where the money is coming and going. Some banks might make you call them and they will overnight a check.
Tips & Tricks
What people don’t understand about HELOCs are the various ways you can go about using them to improve your financial situation. Here are some I know about.
Money Merge Account
One of the coolest features of a HELOC is a little trick you can do to help pay down your bills or the balance on your mortgage. There are a couple companies that sell a similar product called a Money Merge Account. Ill show you how to use your HELCO just like it for free.
On the HELOC you pay little interest on big amounts. Example: $125k 30 Year Fixed Mortgage at 6% has $750 monthly payments where $625 of that is interest. So only $125 goes to pay down the loan. Over one year your balance will go down $125 x 12 months = $1500.
Lets say one month you write a check from your HELOC for $2k towards one months payment on your first mortgage. Your payment is $750 so $1250 went on top of the loan to pay down the first mortgage balance.
That $2k is now a balance on your HELOC where your payment (I’ll use 7%) is $2000 x 7% = $140 interest in one year / 12 months = $12. What you effectively did was transfer a lot of interest from your first mortgage to the HELOC.
You basically are going to double the amount of principle you pay off on the mortgage every year. Which in the long run will save you in the tens of thousands of dollars in interest. When you get your HELOC bill the next month all you have to pay is the $12 but you should pay $750. Pretty cool huh!
Consolidating Credit Card Debt
Let’s say you have $30k in credit card debt spread over 3 different credit cards with an average interest rate of 19%. You pay $1,200 a month total to them.
If you never use your credit card again and just make the $1,200 a month payment it will take you 16.7 years to pay off the entire credit card balance and you will pay $19,469 in interest on that $30k. So the $30k you racked up in credit card debt really costs you $49,469 over a 17 year period (you can figure this out with a credit card payoff calculator).
Lets say you are able to get a HELOC at 6% with a $50k maximum line of credit but only need $30k to pay off the credit card debt. This is a lot better then the 19% you were paying on your credit card. Right off the get go you are saving 13% in interest and getting a bigger tax write off too. Good news everywhere.
Monthly HELOC payment on the $30k at 6% is $150 interest only. A easy way to figure this out is take the balance $30k x mortgage rate of 6% = $1800 which is your yearly required interest payments, than divide by 12 which equals $150.
You go from paying $1,200 a month on your credit cards to $150 on your HELOC. This saves you $1,200 – $150 = $1,050 a month in payments. Over a year that is $1,050 x 12 months = $12,600 in cash back in your pocket.
Imagine how fast you could have $50k saved up in a savings or retirement account now. The best thing you could probably do is make the $1,200 a month payment you were making to the credit cards towards the HELOC.
The balance will drop by $1,200 – $150= $1,050 a month. In a year you could pay down $12,600 of the balance. If you made the $1,200 payment every month you would have the home equity loan paid off in 2.23 years.
This is much better than paying interest on credit cards for 17 years. What is also neat about the HELOC is that your payment re-adjusts every month to the new payment. Let’s say you get the balance down to $20k. Your required interest only mortgage payment will be just $100 a month. It pays to pay more.
Buying A Home
This one might be tricky as only banks and credit unions have HELOC’s available to buy a home with. Why this is a great idea is the closing costs on these are the same as if it was a second mortgage. Right around $500 versus $3,000 with a conventional 30 year mortgage. Thats a lot of savings.
From what I’ve seen you have to put a 20% down payment to qualify along with the usual things like good credit and assets.
Even though the interest rate will be variable and tied into the prime rate set forth by the Federal Reserve it typically is not changed much. And if it is its usually .25%.
What makes buying a home with a HELOC an interesting play outside of the savings with the closing costs is you are only required to pay interest every month. With it being a 30 year loan and the first 10 years being interest only you can have some very low payments.
Another cool thing is you can make larger payments to it every month to pay down the principal balance. When you do that, the following month your interest only payment will be less as it recalculates based on the new principal.
Oh, and you can borrow against it in the future if you’ve paid it down.
Refinancing A Mortgage
Huh? Lets say you have $200k in equity in your home and a $120k first mortgage. You could take out a HELOC for $180k (lets say), pay off the first mortgage of $120k, and leave yourself $60k on the line of credit to borrow against in the future.
Same thing as the scenario above in buying a home. Interest only payments for 10 years based on a 30 year payment. Closing costs of $500 versus $3000. The HELOC slides into first lien position on the home as the old mortgage is paid off.
This is a clever way of refinancing your mortgage.
All in all the HELOC gives you a ton of flexibility with your finances and can be considered your emergency fund in tough times. These are not to be confused with a fixed second mortgage which is basically a loan. A HELOC is accessible money to be used whenever you seem fit.
I have one with my house and plan to keep it open for the foreseeable future.