Is a Home Equity Line of Credit or HELOC Right for Me?
A Home Equity Line of Credit (HELOC) can be an attractive option for homeowners looking for short-term financing. However, it’s important to understand that a HELOC isn't suitable for everyone. Years ago, I spoke with a man that had a good size 1st mortgage as well as a HELOC. The HELOC was used to buy two cars and to travel. Not ideal.
Let’s look at when a HELOC might make sense and use an example to illustrate its potential advantages.
Understanding HELOCs
A HELOC is a type of loan that allows you to borrow against the equity in your home. Unlike a traditional mortgage, a HELOC functions more like a credit card, where you can borrow up to a certain limit and only pay interest on the amount you’ve borrowed. This flexibility can be particularly useful for covering short-term expenses or managing cash flow needs.
When a HELOC Might Be Right for You
A HELOC could be beneficial if you need access to funds for a short period and have a clear plan to repay the borrowed amount. It’s often used for home improvements, medical expenses, or other significant but temporary financial needs.
Let’s say your heating system died and you need to put in a new one and the cost is $12,000. If you have an emergency fund set up and funded with at least six months of living expenses, you may be able to pull the money needed from there but if you are like many, you may not have that much cash available.
Another choice is to take it out of an investments account. I don’t generally recommend pulling money out of a retirement account for non-retirement reasons but if you have non-retirement money this could be a place to pull from. You do want to be mindful of capital gains taxes when selling an investment so be sure to look carefully at that.
Here’s another scenario that might be a fit to fund a cash need.
Consider someone with a substantial IRA, say $1,000,000, who only needs to take out their Required Minimum Distribution (RMD). Suppose this individual has a daughter who needs $50,000 a year to meet her expenses for the next five years. Instead of withdrawing $50,000 annually from the IRA, which could have significant tax implications, the parent might consider using a HELOC to cover these expenses.
The Financial Impact
Let’s break down the numbers:
- Year 1: The parent borrows $50,000 from the HELOC. If the interest rate is 8%, they would pay $4,000 in interest.
- Year 2: They borrow another $50,000, making the total borrowed $100,000. The interest for the first $50,000 remains $4,000, and for the second $50,000, it’s another $4,000, totaling $8,000.
In this scenario, the interest payments increase incrementally. Here’s a simplified breakdown of the interest costs over five years:
- Year 1: $4,000
- Year 2: $8,000
- Year 3: $12,000
- Year 4: $16,000
- Year 5: $20,000
By the end of five years, the total interest paid would be $60,000*. Bear in mind, they would now have a balance on their HELOC of $250,000.
Comparing HELOC to IRA Withdrawals
If the parent were to withdraw $50,000 annually from their IRA instead, they would not only reduce their retirement savings by $250,000 but could also face higher taxes due to the increased income. The tax implications of large withdrawals can be significant, potentially outweighing the cost of interest on a HELOC. (There are no taxes to pay when borrowing money on a HELOC)
Conclusion
A HELOC can be a useful tool for those who need short-term financing and have a plan for repayment. It’s crucial to weigh the costs and benefits, especially when comparing it to other financial strategies like IRA withdrawals. For those with significant retirement savings and specific short-term needs, a HELOC might offer a more tax-efficient solution.
In this hypothetical example, a couple of things applied. One, the parents aren’t planning on moving before the five-year mark, but do plan on selling shortly after. Two, there is no mortgage on the property. Three, the home is worth much more than the HELOC limit amount. The parents are totally okay with paying this loan off when they sell the house.
*This is a hypothetical example as the interest rate over the 5 years may not be a constant 8% as HELOC’s are not a fixed rate loan. Also, in this hypothetical, it is assumed the interest is paid off in full by the end of the year before the next 50k is withdrawn and depending on how the interest is calculated, could result in different amounts.
Always seek the advice of a tax professional and Certified Financial Planner™ practitioner before making any financial decisions.
Have questions or something I may be able to help you figure out, schedule a quick complimentary call with me by clicking HERE to see my online calendar
Click HERE to receive our weekly newsletter. You can unsubscribe at any time.
Here is another blog article that might be of interest. Why You Need a Rock-Solid Financial and Estate Plan – Before It's Too Late
All the best.
Rick Fingerman, CFP®, CDFA™, CCPS®
617-630-4978
Rick@PlanWithFPS.com
Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, medical, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS