Regular readers know that I recently saved over $22,000 in 90 minutes by refinancing the mortgage on my primary residence. After refinancing, I opened up a new home equity line of credit (HELOC). Why? …because whenever you refinance a mortgage, the bank has to close out any existing liens on the property, which includes your HELOC. So I closed out my old HELOC and opened up a new one.
Are you familiar with HELOCs? They are awesome, and if you’re not familiar with them, read on!
What is a HELOC?
HELOCs are similar to mortgages in that they are loans you can get as a homeowner that are guaranteed (secured) by the equity in your property. Consequently, the interest rates are very good compared to an unsecured loan, such as a credit card, and the interest on the first $100,000 that you borrow is usually tax deductible if you itemize your taxes (check with your accountant).
HELOCs are different in one important respect from home loans, however. They are a line of credit and not a loan. That means that the cash is available if and when you need it, but you do not have to borrow it if you don’t want to. A home loan is a fixed amount of cash that is lent to you to purchase a house and then must be repaid over a certain period of time with fixed monthly payments.
With a HELOC, you have to make a minimum monthly payment, but you don’t have to pay the whole thing back until the term of the HELOC is over, typically ten years. If you want to pay it back sooner, that’s fine too. It’s similar to a credit card, but with a substantially lower interest rate.
Do you see the difference? The HELOC is simply there if and when you need it, and you don’t pay interest on the money otherwise.
Limits on HELOCs
Just like with mortgages, banks want to make sure that your house is worth more than what they are lending you – and they want to have a little cushion in there as well. For a HELOC they will normally lend you up to 80% of the value of your home, less the outstanding balance on our home loan.
For example, if your home is worth $300,000 and you have an outstanding mortgage balance of $200,000, the bank will let you open up a HELOC for $40,000. This is 80% of your home’s value ($240,000) less the mortgage balance.
Once you open up a HELOC, the amount you can borrow from it (also called the credit limit), does not change. So, even if you pay down your mortgage by tens of thousands of dollars over the following years, your HELOC credit limit, in this case, would stay at $40,000.
If you wanted to increase your credit limit, you would have to close that HELOC and open up a new HELOC. The bank would then re-appraise the house, take 80% of its value and subtract the remaining mortgage amount to see how high your new HELOC credit limit would be.
When to Use a HELOC
We have had a HELOC in place since the moment we had enough equity to get one. Why? Back in 2008, I had a financial wake-up call when I almost got laid off (see why I started this blog) from my corporate job and realized I needed to beef up our emergency funds ASAP. Over the next couple of years, I was able to build up cash reserves to cover six months-worth of living expenses. Then, I came to the big realization.
I could use my emergency funds to pay down my mortgage and then open up a HELOC to use in case of an actual emergency. My emergency fund went from six months-worth of cash, making almost no interest, to over a year’s worth of living expenses with the HELOC at no cost to me – a win-win! I’ve been a huge fan of HELOCs ever since.
Since the interest rates are generally so low, and in our case the interest has always been tax deductible, it is almost like free money. Here are some other uses for a HELOC:
- Pay down higher interest rate credit cards
- Pay off a high-interest car loan
- Pay for your kid’s college costs
- Typical emergency fund issues – layoff, medical expenses, insurance deductibles, etc…
One big caveat, however, you should never use it to buy things that you couldn’t afford in the first place, and you should never use it to fund lifestyle inflation.
Since you are tapping into your accumulated home equity, it should only be used for genuine emergencies, or for an inexpensive way to finance something that you were going to finance anyway, like a car.
If you’re interested in getting a HELOC, the process is simple, read on to see how.
How to Open a HELOC
Before even considering opening up a HELOC, you should make sure that you have enough equity in your home to warrant it. I’d recommend checking out your home value with a free service like Zillow, asking any real estate friends, or looking at recent home sales in your area to get an idea of what your home might be worth.
You should be able to estimate the value of your home within a reasonable margin of error relatively quickly. Take 80% of the value and subtract the outstanding balance of your home loan. How much is left? Will it be enough for your needs? If there’s enough equity, then consider a HELOC.
If you are interested in a HELOC, here are the next steps:
- Use a free service like Lending Tree to compare interest rates from several lenders.
- If you know a mortgage broker or have access to a credit union, take your best deal from above and see if they can beat it.
- Pick your preferred lender and start the paperwork.
- Enjoy the peace and security of knowing you have a line of credit available if and when you need it!
HELOCs are Awesome
Have I convinced you that HELOCs are awesome? They are inexpensive to open and make it easy to access the equity in your home when you need it. I also think they’re a great way to maintain an emergency fund.
If you are a homeowner, do you have a HELOC? Why or why not? Do you think they are dangerous for people with low self-control?