Cash and debt management can be an ally or detriment to a person’s financial well-being. In today’s information age, personal finance tools are plentiful. However, many are unknown, misunderstood, or aren’t applicable to one’s lifestyle.
A constant theme we address with clients is a desire or need for improved cash flow and/or liquidity. And sometimes, little do they know, a resource may lie right beneath their feet…literally.
A Home Equity Line of Credit (a.k.a. HELOC) may be a solution to add flexibility to your cash management practices. HELOCs have been on the financial scene since the 1990s. On March 31, 2016 Forbes wrote an article titled “Your Neighbor Got a HELOC, Should You?” and stated “Over 37 million borrowers have an average of $112,000 equity available to tap in their homes…”. For some home owners, putting this equity to use could provide multiple benefits. Let’s explore a few and don’t worry, it’s not a one-sided conversation – we will examine the disadvantages as well.
Benefits of a HELOC:
Added flexibility: you can borrow as much (up to your limit) or as little as you wish, as your circumstances change. Your payments should vary each month depending on the amount you owe at time of said payment. It's a bit like a credit card in that respect.
Added liquidity: often, we find people that don’t have the ability to take advantage of potential opportunities due to a lack of cash on hand. A HELOC could add that needed liquidity. Whatever your credit limit is (i.e. $25,000), you can access that cash whenever you may need it, providing you with a higher level of liquid assets, which can be advantageous.
Convenience: most HELOCs can provide cash immediately upon request, via multiple avenues such as: online transfer, phone call, checks, or even a plastic card.
Added level of emergency funds: a greater sense of security can be accomplished in knowing that an added level of emergency cash can be made accessible if the need arises.
Better credit score: HELOCs show up on your credit report as revolving lines of credit, similar to a credit card. However, credit bureaus view these credit entries as mortgages, which is more favorable for the borrower. Having established these lines, and keeping the majority, or all, of the line unused, allows for a borrower to show low credit utilization – the lower the better. Credit utilization accounts for approximately 30% of an individual’s credit score – looks like a HELOC could help.
Tax deductibility: if your HELOC was used to improve your home, you may deduct interest on lines up to $1 million ($500,000 married filing separately). If your HELOC was used for other purposes, you may deduct interest on lines up to $100,000 ($50,000 married filing separately). Please refence the footnote below for further details on the tax deductibility and we highly recommend consulting with a tax professional regarding this benefit.
Debt consolidation: HELOC rates, since tied to collateral (i.e. your home), tend to have lower interest rates when compared to other loans such as: personal loans, credit cards, and possibly student or auto loans. Most HELOCs are amortized over a longer period compared to other types of loans - typically over 25 years. This can present lower payments and thus cash flow relief if needed.
Okay, now, this concept is not for everyone and can’t be the “fix all” solution. As Yoda might say (there’s a new Star Wars movie out) “Financial restraint one must have” (just imagine Yoda saying that – AWESOME!). Without constant discipline, problems could appear. Remember, this is like having one HUGE credit card and behind that card there are doors, windows, and a roof. With that said, let’s look at some disadvantages.
Disadvantages of a HELOC:
Possible upfront costs: most HELOCs have closing costs, which are paid to the financial institution. These closing cost include property recording costs and appraisal fees.
Variable rates: some HELOCs offer introductory rates, which change after a subjective period of time. Be aware of this component – typically, these products are linked to an adjustable rate, most commonly found to be the prime rate. A borrower must understand that their rate can change, thus impacting their payments. Some institutions will also offer a fixed rate for a period of time on their HELOC products.
Poor spending habits: like a credit card, if a person finds revolving lines to be a temptation to spend, then a HELOC can present a major issue regarding the overextension of debt.
Minimum draw amounts: some HELOCs have “draw” periods and these terms can be restrictive. For example, an individual might be able to pay interest-only payments for five years and after this period, they may see an increase in their payments as the payment structure could begin to include principal and interest. Overall, understand your HELOC’s terms and read the fine print!
We understand the advantages and disadvantages, but what do institutions consider when determining approval for a HELOC?
Financial institutions have multiple risk assessments depending on the organization. Commonly, the following may be considered:
Credit score (sometimes your bankruptcy score, as applicable)
Income relative to your debt (a.k.a debt-to-income or DTI)
Borrowed amounts on the property relative to equity value owned in the property (a.k.a loan-to-value or LTV)
Relationship to the financial institution
If you haven’t already paid it off, at what institution your first mortgage currently exists
Unsecured debt (debts not tied to collateral such as a home or vehicle)
As one can see, there are multiple advantages and disadvantages to HELOCs and they are not the right fit for every situation. If you feel you could benefit from a HELOC, please feel free to contact us. We would be happy to explore this concept in great depth and assist in concluding whether this is an appropriate option for you and/or your household. Some institutions, from time to time, are willing to open a HELOC and waive the closing costs discussed earlier. If there is value in having a HELOC, we can point you in the right direction of competent, trustworthy bankers.
 If LBW refers clients or prospects to professional contacts such as a personal banker, LBW does not receive any compensation for referrals from such professionals.