Overview
A home equity line of credit, or HELOC, is a line of credit that is secured by your home. They’re most commonly used to cover the cost of home improvement projects, but they can have financial planning benefits beyond that. Here we’ll look at the basics of HELOCs as well as their benefits and considerations to see how one might fit into your financial life.
The Basics
To qualify for a HELOC you need to own a home, have good credit, and have income (e.g., from a job, rental real estate, Social Security, or an IRA distribution). The maximum line of credit depends on both the value of your home and your mortgage balance, but some banks offer up to one million dollars. Most lenders loan up to 85% of the home’s equity, and some go as high as 90%.
For example, a $1,500,00 home with a $1,000,000 mortgage balance:
- $1,500,000 x 85% = $1,275,000
- $1,275,000 – $1,000,000 = $275,000, your maximum line of credit
The line of credit is typically available for 10 years. If you do not withdraw from the account during that time you pay no interest. When you do withdraw funds, the monthly payment is based on the outstanding balance. For instance, you may have a $100,000 line of credit but withdraw only $25,000. You would then pay interest on the $25,000.
Interest rates are typically variable and based on the “Prime rate” plus approximately a half percent. As of November 2019, that translates to about 5.25%. Fixed-rate products are available but are less common.
Benefits
- Tax Deductible: If you spend the money on building or substantially improving your home the interest may be tax deductible. To be eligible for the full deduction the combined value of your first mortgage and HELOC must be $750,000 or less. Otherwise, only part of the interest is deductible. To read more on these qualifications, see here.If you do qualify for the full tax deduction, here is an example of the benefit. If you withdrew $100,000 from a HELOC with a 5.25% interest rate, the interest payment equals $438 per month, or $5,256 per year. If you are a California resident in the 9.3% tax bracket and the 24% federal tax bracket, writing off the interest saves you $1,750 in annual taxes ($5,256 x (9.3% + 24%)). Said another way, the net cost of a HELOC in this situation is only 3.50%.
- Flexible: You can set up a line of credit and pay contractors or other home improvement specialists directly when the timing makes sense, now or in the future. By paying them directly, you also create a clear accounting of your construction costs for future tax purposes.
- Emergency Fund: It’s important to have cash to cover unexpected emergencies. However, if that cash is not enough when an emergency occurs, a HELOC is a good backup.
- Tax-Free Withdrawals: When you withdraw from a HELOC there are no taxes, and you receive exactly what you withdraw. In other accounts that is not the case. For instance, if you withdraw from a rollover Individual Retirement Account (IRA) you typically would owe state and federal income tax. This makes HELOCs a good option when paying the interest on a HELOC is less onerous than paying the income tax from an IRA or brokerage account withdrawal.
- Debt Replacement: If you have credit card debt, which typically has an interest rate of 15% – 20%, you can use a HELOC to pay off that debt and achieve a lower monthly payment.
Considerations
- Upfront Work: Home equity lines are mortgage products that require paperwork, conversations with your mortgage advisor, and a home appraisal.
- Default Risk: Just like with your mortgage, defaulting on your HELOC could result in foreclosure.
- Possible Freeze: If your home value drops substantially, as happened during the 2008 – 2009 recession, the financial institution supplying your HELOC has the option to freeze or reduce your line of credit, which reduces the amount you can withdraw or eliminates the option completely.
- Costs: The costs to set up a HELOC are usually covered by the financial institution, but it’s worth asking about those upfront or ongoing fees early in the process.
Conclusion
Although HELOCs take time to set up and have risks, they offer great flexibility with the opportunity for significant tax advantages on home improvement projects. They also can act as a backup emergency fund, can replace high-interest debt, and may allow you to avoid unnecessary withdrawals from retirement or other investment accounts. They may be especially beneficial if you are near retirement and have the income to qualify. This allows you to have a HELOC in place during your early retirement years to aid with your cash flow needs or future construction projects. While they’re not a fit for everyone, they’re certainly worth considering.
