A home equity line of credit (HELOC) is an interesting entity. In essence, it’s a line of credit that a lender gives you using the equity in your home as collateral. A HELOC is similar to a home equity loan and this sometimes causes confusion with borrowers. There are a few differences between the two though…
Home Equity Line of Credit (HELOC)
- Does not necessarily advance you all the money at once – you are given a line of credit you can draw from as needed (similar to how a credit card works). This amount is based on a certain percentage (say 70-80%) of the amount of equity you have in your home – this is known as the loan-to-value (LTV).
- Possibly does not require a full onsite appraisal.
- No formal closing and lower (if any) closing costs.
- The line of credit has a variable interest rate.
- Minimum payment is determined by the amount owed at the time each month. If no additional money is withdrawn, then the minimum payment goes down each month.
Home Equity Loan
- Lump sum amount taken out all at once. Similar to a HELOC, the amount is based on the amount of equity in your home.
- Full onsite appraisal is usually required.
- Closing costs and a formal closing will need to take place.
- A home equity loan generally has a fixed interest rate.
- Loan payment is the same each month.
So you can see that there are some major differences between the two types of financing. They each have their place and, depending on what your needs are, one may be better than the other.
Today, however, we’re going to focus on the Home Equity Line of Credit (HELOC). Here are a couple of ideas of where a HELOC can be used in a good way (if careful)…
Use a HELOC as an emergency fund
If you remember, initially I was planning on getting a HELOC just to have in case of emergencies because I had used a sizable chunk of our savings toward the duplex we purchased. We didn’t end up going that route at the time because we talked to the loan officer at our credit union and learned we were required to take a $5,000 draw at the time of getting the HELOC.
Because we only wanted to have the line of credit “just in case”, we didn’t actually need the $5,000. We also learned that the whole process could be turned around in a couple of weeks. So we decided that we could always rely on credit cards if a true emergency came up and then possibly open a HELOC at the time if needed while we built up our savings again.
The important point to keep in mind if you plan on using a HELOC for emergencies is that your home is on the line. If you draw from the HELOC to take care of a catastrophe and then lose your income during the payback period, you could be setting yourself up for a foreclosure, which no one wants (not even the bank really).
The other downside is that the line of credit becomes tempting to some people. And just like credit cards, if it doesn’t get used properly and is used to buy crap instead, it can cause unnecessary debt. Don’t let this happen to you.
Pay Off High-Interest Loan/Mortgage
We decided against using the HELOC for an emergency fund, but have since found another way to make it work for us. We were in an odd situation with our first rental house. We owed around $40,000 on it with a 5.125% fixed rate on the mortgage. That rate isn’t horrible, but there have been some fantastic refi rates over the past few years that we wanted to take advantage of. We were also ahead of schedule and planning to have the balance paid off in about ten years.
Unfortunately, with the relatively low amount of financing needed, most banks didn’t even want to bother putting the time into doing a refi. Plus, it would be difficult for us to be able to recoup the closing costs we would be incurring in the short amount of time we had to pay it off.
So we sat on this for a little bit. But then, my financial mentor mentioned a great idea. He threw out the thought of using a HELOC to pay off the property. We had to contemplate the risk versus the reward on this.
The HELOC could only be done on our residence because the property value of the rental isn’t enough. With a HELOC, there were $0 in costs so that made it a good option. And at a 3.5% rate while continuing to make the same payment we were making, I figured I could shave a year off the payoff! But (and that’s a big ol’ “but”), the 3.5% is a variable rate and the assumption is that the rate doesn’t go up fast enough to eat away at that year of savings.
We decided that it made sense and, if rates jumped up too much (pretty unlikely), we could pay it off outright or get another loan if necessary. When we went through the process and the loan-to-value (LTV) ratio was determined, we were about $3,000 short of what we needed. Now, if we were dealing with a bank, that’s pretty much the end of the story.
However, let’s throw a shout-out to credit unions. The loan officer and I talked – basically we needed to adjust the LTV from 70% to 75% to be able to cover the cost of paying off the rental house mortgage. She went to the board of directors and then called me the next day and said it was a no-brainer and we got the full amount. Credit unions (and some smaller banks) have the flexibility to work with you on these kind of things.
Using a HELOC to pay off a higher rate loan can be a wise move if done carefully. And I hope to be able to prove that to you when we have the rental house paid off in the next handful of years!
Remember, a HELOC is a very powerful tool. If used correctly, it can put you in a much closer position toward financial independence. However, if not used intelligently, it can just pour further debt on your life and ruin you the same way credit cards have the ability to do.
Have you ever used or considered using a HELOC to help put yourself in a better financial position?
Thanks for reading!!