What does a dad do when he leaves the house? HELOC’s the door! Sorry, it’s been a couple of months and I had to start with a dad joke in honor of Father's Day. So good to be writing again! For loyal readers, I mentioned I wouldn’t be able to consistently publish blogs because I would be busy with some other things in life. Well, besides moving to a new home, I’ve taken on additional work in my day job... and my wife and I became property investors! I’ll write more about this in future blogs, but I wanted to focus on one thing I learned first-hand in the midst of property investment: HELOC’s. For those unaware, a HELOC is a Home Equity Line of Credit. Think of it like a credit card – except you’re borrowing against the equity you’ve built up in your home. As you can imagine, this money could do a lot of good for some individuals. Or wreak havoc on their long-term financial goals. So let’s break down HELOC’s and when it does or does not make sense to use them.
Fun fact: after his locksmith day-job, he's a mime in Time Square!
HELOC Details
Let’s start with basics: how do you get a HELOC? Many financial institutions and mortgage loan companies will offer a line of credit to qualified buyers. Similar to a mortgage, you will need to apply for a HELOC using your personal financial information, a credit score, and an appraisal of your home. If you’re concerned about up-front costs, the fees are substantially lower than a mortgage. Typically, you can borrow up to 85% of your home’s equity (appraised value minus principal remaining on mortgage). Interest rates tend to be higher than a mortgage rate, but substantially less than other lines of credit like a credit card. Once you’ve applied and closed, you will have access to your money immediately. You can withdraw from your HELOC and pay it down immediately, only paying interest on the money borrow. For example, say you had a HELOC of $100,000 and only borrowed $10,000 for a year. If your interest rate was 5%, you would owe $500 for the interest on the $10,000 after a year. You would still be able to borrow the difference ($90,000), but as soon as you withdraw, you start owing interest on that money as well.
HELOC’s have other considerations as well. You typically have a “draw” period and a “payback” period. A common arrangement is a 5-year draw period where you can withdraw as much of the line of credit as you wish. During those five years, the interest rate remains the same. Once you’ve completed the five years, you have a payback period (often 10+ years) where you have to pay back what’s owed plus interest. You can no longer draw new money, only pay down what’s borrowed. Additionally, the interest rate during the draw period is usually fixed, while the payback period can vary. Using the example above, your interest rate during the draw is 5%, but if rates increase, you could be paying 8% during the payback. You likely will need to pay back interest monthly during the draw period, while the payback period is principal plus interest to get back to zero balance at the end.
It’s The Worst!
Now that we’ve covered the mechanics of a HELOC, let’s focus on the negatives of using one. First and foremost, you’re borrowing against one of your biggest financial assets. Assuming you still have a mortgage, you now have two lenders with stakes on your home. What happens if the housing market crashes, you lose your job, and can’t pay your mortgage and/or HELOC? You could lose your home much more easily. Compounding the problem, you’re likely paying a higher interest rate on the HELOC than your mortgage and you may have spent hundreds just to get the line of credit.
There are alternatives to a HELOC that may make much more sense in your situation. First, consider a cash-out refinance. By refinancing your original mortgage, you can potentially get a better interest rate, withdraw more cash, and still get the money you need. The downside here is that, because it’s a mortgage and not a line of credit, all of the cash comes out at once and you’re paying interest right away. Also, once you’ve paid it back, you can’t draw it out again. You could also take out a personal line of credit (borrowing against your credit history and debt-to-income), borrow against your 401(k), or various other loans.
It’s The Best!
HELOC’s offer a lot of advantages - in the right circumstance. For example, investing money back into your property. Say you have been in your home a few years, and realize that kitchen is just not cutting it. You’re trying to chop veggies while your spouse squeezes by to get plates to the table, plus your toddlers are rumbling around your feet cramped around the only prep surface. Basically, picture any commercial for buying a new home. But say you like everything else about your house, and really don’t want to move. While having the cash on hand to do a full kitchen remodel is not practical (prepare for $50-150K expenditure depending on your market and tastes!), a HELOC may be ideal. It’s a fairly low-risk maneuver as you’re essentially borrowing against your equity to reinvest in your home, and as long as you can afford to pay it down and (eventually) off, it's a reasonable decision.
What else would qualify as a good use of a HELOC? Any ad your hear or see for taking out a HELOC will mention paying down other higher-interest debt (credit card, car loan, etc.). I’ll tell you what my wife and I did. For context, we got a nice home in 2017 at a great price, invested in a major landscaping project, and benefited from a great housing market over 4 years. We were sitting had a good amount of equity in the house. As something of a COVID escape, I was researching residential and commercial property investment. Fast forward a bit, and we suddenly found ourselves with an accepted offer on a property in a nice, vacation town near my home. I will share more details in a future blog, but we have now turned this property from a commercial building into a residential duplex, with one side as short-term rental (STR) and the other as long-term. It’s been quite the adventure, but so far has been a great experience. All things considered, I feel this is a great use of a HELOC for a few reasons. First, you aren’t taking out new debt, just borrowing against equity in your current home. Second, depending on your property investment, you’re diversifying your real estate investment. Real estate is a tricky investment for many reasons, but one thing’s for sure: it’s very local! It’s not just a country, or even a state. Buying in the right city or neighborhood is so important. So much goes into this decision, and probably a dedicated blog on its own!
Conclusion
So should you get a HELOC or not? It all depends on how you’re using it. The inherent risk of a HELOC is not being able to pay it off – which can mean risks to the roof over your head! That said, it’s just a line of credit, and you should only pull money out that you’re confident you can repay. If your money is going to some sort of asset/investment or paying down higher-interest debt, it could be the right move. It’s worth noting that, as of the publish date of this blog, interest rates have skyrocketed in recent months. Whatever your circumstance, the rates will drive any decision and run the numbers before making a move. Glad to be back and hope it’s not this long until the next one!
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