A HELOC, or Home Equity Line of Credit, is often viewed as a “second mortgage.” But when should a homeowner consider a HELOC? And are they actually a safe way to borrow? Let’s find out.
Essentially, a homeowner could leverage the equity they’ve built over the years to act as collateral for a loan. A lender, typically your bank, will determine your eligibility for a HELOC by looking at:
Most banks have a ceiling for how much they can lend a homeowner in a HELOC. This is a combined loan-to-value ratio (CLTV). Usually, banks lend an average of an 80%+ CLTV to homeowners who have a good credit score. The loan amount you’re eligible for is calculated by taking the total amount your home is worth, multiplied by their predetermined CLTV percentage, less the total amount still owed on the home. So, if your home is worth $400,000, you owe $200,000 on your mortgage, and your bank is offering an 80% CLTV, your eligible HELOC amount would be:
$400,000 x 0.80 = $320,000 - $200,000 = $120,000
It’s important to note that interest on a HELOC is no longer tax deductible as of 2017 due to changes made through the Tax Cuts and Jobs Act.
Because a HELOC uses your home as collateral, the loan is viewed as more secure from a lender’s perspective. Often, this can help to “lock in” lower interest rates for borrowers, especially when compared to a credit card or high-interest personal loan. However, HELOCs are structured differently than many other loan types. Typically, a HELOC will start with interest only payments. Then, in the last 10 years or so of your loan term, principal payments start.
This can increase your monthly payments significantly. It’s also critical to remember that many HELOCs are set up to have an adjustable interest rate. This means that your interest rate, though low when you first take out the loan, can fluctuate and increase (or decrease) over time. Having a strategy to pay down your HELOC is important to ensure that you avoid running up against either increasing interest rates or monthly payments over the life of the loan.
Often, homeowners will leverage a HELOC when they’re interested in improving their home. In these cases, the money you’re borrowing against your property is being reinvested to increase the home’s value - and, feasibly, pay off the HELOC more efficiently if you were to sell in the future. Because your HELOC will be paid out in the form of a one-time, lump-sum payment, you can use the funds however you choose.
However, if you’re planning on using a HELOC to fund large personal expenses (like a vacation or a new vehicle), or to consolidate high-interest debt, you might want to reconsider. The truth is that HELOCs, while handy, use your home as collateral. Should your financial situation change, and you find yourself unable to pay for your lifestyle (and the payments on your HELOC), you could lose your home.
Want to know more about whether or not a HELOC makes sense for your unique situation? Reach out! We’d love to speak with you.
Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs, and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.
"Finance Made Simple" blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.