The feeling of having a home equity line is a lot like owning an RV. Many don’t know why they bought it, are not using it, and are paying unnecessary costs. Others, however, are using it at the right time and swear that having one is well worth the hassle. A home equity line is a variable rate loan that can be used for a variety of purposes, whether as a fall back to an emergency fund or for more strategic purposes. We will review the mechanics of the home equity line of credit (“HELOC”), when to utilize it, and words of caution.
How do Home Equity Lines of Credit Operate?
With a HELOC, you establish a line – access to credit -- similar to a credit card. In the case of a home equity line, when you draw on the line, i.e., you take out a loan using the equity of your home -- your home serves as collateral similar to a mortgage. The borrower can generally draw on the line up to a certain dollar amount, limited to the lesser of the debt to equity limits or to a hard dollar cap. The interest rate is usually variable, and the payment terms are generally interest only during the draw period (typically ten years). The initial rate is generally lower than your typical mortgage, but such rate can later increase to a rate that is well above a mortgage where the rate was locked in for several years.
There are other nuances of the HELOC, including credit score, caps, and costs involved. You will need a good credit score to qualify – typically, most lenders require a score of 680 or higher.
As mentioned earlier, the maximum that a borrower can take out on a home equity line is generally the lesser of a debt to equity ratio or a dollar cap amount. The total debt to equity in your home (including your mortgage) is often limited to 80%. The cap varies by institution, generally ranging from $100,000 on up to $500,000, depending on the lending institution, the credit score, the debt to equity, and other factors. The vast majority of lenders seem to have a cap of $250,000 or less so you will need to do some shopping if you want a higher cap.
Moreover, you will need income to qualify since lenders also look to the debt-to-income ratio (“DTI”) even for home equity lines. Your DTI is the total amount of your debt payments divided by your monthly income. Generally, you need to be at 43% or lower DTI to qualify for funding. For those that are nearing retirement, it may be especially beneficial to apply for a home equity line before your stable salary goes away. While there are various ways to “create income” to qualify for a HELOC during retirement, these various ways to qualify are often disadvantageous and counter to the particular reason you are seeking a HELOC, e.g., tax planning.
Make sure you understand the closing costs involved. While in some cases the closing costs can be as high as 2% - 5% of the loan, shop around to find minimal closing costs. Some of these costs may include an application fee, credit report, appraisal, title search fees, attorney’s fees, and recording fees. In many cases, many of the fees are waived or paid by the lending institution. Of course, if they are paid by the lending institution, make sure you are comparing apples to apples among lenders – the lender may be waiving the closing costs only to reap higher profits with higher interest rates or other junk fees. Some banks will waive the initial fees, while other banks will charge various closing costs such as appraisal fees and attorney fees. If fees are waived, make sure you are comparing interest rates because the waived fees may be embedded in the interest rates. Needless to say, be sure to read the fine print so that you understand the terms of the HELOC.
When Should You Use a Home Equity Line of Credit?
After having reviewed the mechanics of a HELOC, let’s look at potential uses of this arrow in your quiver. It should not be used to buy the car that you cannot afford or to take that European trip that your cash flow cannot support. However, a HELOC can be used for more strategic purposes.
First, it can be used as a back-up emergency fund. Note that I used the term back-up. The HELOC should not replace the traditional emergency fund that consists of cash in a financial institution. Typically, we recommend having an emergency fund of 3 months to 12 months, depending on the circumstances. (In most cases, the minimum recommended is 6 months.) An emergency fund is generally recommended if one lost their job or had some other surprise major expense that occurred. (Note that a new HVAC unit, a new car, kids’ braces, or taking a trip to see the Volunteers play in a football national championship are generally not emergency fund-worthy – those expenses should otherwise be planned for using your cash flow or with a sinking fund. You can argue that the Volunteers making the championship was definitely unsuspected, but it is nevertheless not emergency-fund worthy.) The HELOC can thus serve as a secondary emergency fund reserve for the right person in the right situation.
For example, if you lost your job in a deep recessionary market and had major health bills that were not otherwise paid, then this secondary reserve can be utilized. The HELOC – if the initial closing costs are low enough and the interest rate is reasonable – can be a more effective approach than keeping 12 months or 24 months of cash in reserve. We have seen many individuals keep a lot of cash to meet some of these catastrophic situations. While I like the idea of planning and having contingencies for this matter, a HELOC may be a more cost-effective approach – especially in these periods of low interest rates.
A HELOC can also be used more strategically for tax and non-tax purposes. In some cases, drawing on a HELOC can result in tax savings especially in the early years of retirement. The less tax diversification one has in their investment buckets, the more beneficial the HELOC can be. It can often come into play when you want to limit the amount of taxable income you have in one particular year whether you are looking to do Roth IRA conversions, qualify for the ACA health insurance subsidy (for those pre-65), minimize capital gains taxes or the net investment income tax, or looking to minimize the impacts of Income Related Monthly Adjustment Amount (IRMAA).
For example, let’s say you were trying to qualify for the health insurance subsidy if you retired before age 65. Since this benefit can range from a few thousands of dollars to over $20,000, this is a strategy definitely worth reviewing. Of course, if you are retired, you need some type of cash flow to replace your lost salary. Often times, taxpayers have the option of drawing from their IRA or drawing on Social Security earlier. A disadvantage of this approach is that it adds to their modified adjusted gross income which reduces – and often times eliminates – the ability to get any health insurance subsidies since such subsidies are based on the level of one’s income. By drawing on a home equity line, the borrower has access to tax-free cash flow that doesn’t count as income. This line can then be paid off based on the borrower’s situation – however, again, it should always be looked at as a temporary loan. There are many related tax issues that should be considered with this strategy; while this is not the right approach for many people, but it is an idea worth considering. And, in some cases, a cash-out refinancing – or, no borrowing -- may be preferred, in the right situation.
Drawing on a home equity line could also be used as a buffer during volatile markets. The idea is that rather than drawing on your stocks when the markets have suffered a significant decline, you can draw on your HELOC to meet your cash flow needs with the hopes that the market will recover within a reasonable time. This can be especially important for recent retirees due to the concept of sequence of return risk – the risk that you will need to draw on the funds when the markets are down early in your retirement. This can be especially devastating to individuals if they don’t make adjustments or have not appropriately planned. Thus, the HELOC may help – but not eliminate – the sequence of return risk.
At our firm, we do not rely on a HELOC to minimize the sequence of return risk in the primary position, but I could understand the role it could play for someone without a properly structured portfolio. We have adopted the matching or bucket approach for our retirees to help minimize the sequence of return risk. The bucket approach generally suggests buying fixed income instruments that mature to tie to the retiree’s cash flow for the next 7 – 12 years with the balance of the funds allocated to a diversified stock mix, depending on the markets and the individual’s situation. While the goal is to generally replenish the matched bucket each year as the matched bucket is drawn down, i.e., sell the stock portfolio to buy fixed income, we have the flexibility to replenish the matched bucket based on the volatility of the stock portfolio. We can be patient in selling stocks and buying bonds. In theory, the HELOC can work in similar fashions and can even be used as a supplement to the bucket approach in the right situation.
Risks of a HELOC
While a HELOC can be a good tool in the right circumstances, there are numerous words of caution with a HELOC, of course, and you should always read the fine print of any documents you are signing. Since the rate is variable, these should only be looked at as short-term solutions; you should have a definite game plan to pay back the principal. If you need equity for the long-term, then looking at cash-out refinancing may be more beneficial. (Again, just because you can do a cash-out refinancing does not mean you should.) Also, ensure you have the ability to draw on the line as you need it rather than the bank automatically making distributions to you when you don't need it -- that can create unnecessary interest charges. Moreover, understand if there are any penalties if you close out the HELOC early. In some cases, it might be a few months, and in other cases it might be a few years.Using a HELOC can add flexibility – and resulting benefits -- to your overall financial plan if used correctly. It pays to shop around for the right lender while paying attention to the fine print. If you are looking to understand how your overall financial plan needs more flexibility or you are at the stage of needing more guidance as you approach retirement, please reach out to our team of fiduciary advisors to begin the dialogue.