Use Line of Credit for Flexibility

A Home Equity Line of Credit (HELOC) is a loan in which the equity in your home serves as the security. In other words, it is like any other mortgage in that if you fail to payback the HELOC as you have agreed (the details are in the fine print), the lender can take your home from you and sell it.

A HELOC becomes a 2nd mortgage (assuming that there already exists a 1st mortgage) that may be used to pay for a car, a vacation, education, remodeling or anything else that may come to mind. Furthermore, depending on your particular situation, the Internal Revenue Service may allow you to deduct the interest because the debt is secured by your home. Check with your tax adviser for specifics.

HELOCs are available that allow a “credit worthy” homeowner to borrow up to 100 percent of the equity in their home. The equity in your home is the difference between what your home is worth and what you currently owe on your mortgage(s).

The homeowner applies for a HELOC the same as he or she would for a standard mortgage. The lender will appraise the home and review the homeowner’s financial status and credit report. It should be noted that not all HELOCs require income documentation. Although there may be an annual fee of up to $100, HELOCs typically have little or no closing costs.

Rates on HELOCs are typically adjustable, available at relatively low interest rates and are tied to an index that moves with the economy. The actual rate would be the sum of the index value plus a margin, which is set by the mortgage company or bank. The most popular index is prime rate, which today is at 4 percent. A typical margin would be between one quarter and one full percent. A rate on a HELOC today might be 4.5 percent.

Once the HELOC has been approved and the paperwork completed, the homeowner is given access to the funds through an account that is similar to a checking account. The homeowner has access, via checks, to an amount equal to the maximum limit of the HELOC. No interest is charged and no payments are due until the homeowner taps into some of this money by writing a check.

Once any of the money in the HELOC has been withdrawn by the homeowner, the lender will start sending monthly statements which specify the minimum monthly payment due (usually the interest-only portion) and the remaining balance of credit still available. Funds in the HELOC can be replenished by paying back more than the interest-only minimum payment.

The life term of a HELOC is typically 25 years. Monthly interest-only payments are usually all that is due for the first 10 years of the HELOC term. After that, a typical HELOC will no longer allow withdrawals and will require that the balance of the money due be paid back over the next 15 years.

A HELOC provides a safety net for the prudent homeowner, who uses it as a buffer when cash reserves fall short for unexpected needs, such as medical bills, home or car repairs. As a buffer, money for seasonal expenses such as property taxes, Christmas buying and vacations can be responsibly obtained through a HELOC as long as the homeowner can replenish the HELOC funds promptly (say, within 6 - 12 months).

                These loans can be very helpful and provide the stability needed in a financial plan or they can be abused and become a burden for the homeowner. For example, a homeowner who taps the cash out of a HELOC with no plan on paying it back is asking for trouble. These loans are not bottomless pits of money, they do have a due date and interest rates on all of the indexes will be going up in the months and years ahead.

Homeowners who use up their HELOC funds with no means or intention of paying them back often end up refinancing. That is, replacing their existing 1st mortgage plus their HELOC with a new 1st mortgage that is large enough to payoff both loans. See your mortgage consultant for details.

This column is written weekly by Peter Boutell, Mortgage Consultant and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 or email him at Peter@SantaCruzHomeFinance.com. Visit his website at www.PeterBoutell.com