As real estate markets and financing markets change, there are opportunities to consider in order to build real estate equity in your home. One of those is the Home Equity Line of Credit commonly known as HELOC. During the recession, many banks called in their HELOCs. As the real estate market has improved, the HELOC is emerging as a useful financial planning tool.
Using a HELOC to build equity in your home isn’t for everybody. It takes discipline, structure, and a determined goal. In this case, let’s say your goal is to get your home paid off as soon as possible.
Let’s start with the question, “What is a HELOC?” A HELOC is a simple interest, open-ended line of credit secured by your home. You only pay interest on the balance remaining at the end of each day. Each time you pay the principal down, the interest and payment due is calculated on the remaining balance. In other words, the payment goes down each time you make a principal reduction payment. The unique part, is that if you need the money that you paid down back for an emergency, you can get it back.
Terms of HELOCS vary from year to year and from bank to bank. In general, the HELOC you are shopping for should be a first position loan and open ended so money can flow in and out. Usually, HELOCs are variable rate loans and keyed to an index such as the prime rate. The length of term can vary, but 10 years works very well.
On a typical 30-year mortgage, if you make extra principal payments, your next month’s mortgage payment won’t change. However, the length of the mortgage is shortened every time you make that extra principle payment. You can create your own amortization schedule and pay the extra amount to get your loan paid off by your goal. If you don’t make any extra payments, the loan payoff schedule for a 30-year, 6% loan would look like the graph below:
I like to use the 6% graph as it keeps the math easier for understanding the overall concept. As you study the graph above, you see that very little principal is paid in the early life of the loan. The principal reduction really starts to kick in at about year 14. This is what you really need to consider if you are thinking of refinancing an old loan. Your payment might go lower, but you are likely tacking years of loan payments onto the end of the loan.
For the purpose of this example, let’s compare the idea of using a HELOC instead of the conventional first mortgage. In the interest of simplicity in the example, we will use 6% for the interest rate. The idea consists of you using your HELOC as your checking account. Let’s say you have $5,000 a month in income and your expenses are $4,000. The $1,000 difference is applied to the HELOC each month or $12,000 a year. Interest on the $100,000 and 6% for the year is $6,000. It will actually be a little less, since the balance goes down each month. That leaves $6,000 to go toward principal reduction. Compare that to the graph above where the principal is reduced by $1,228. This only works, of course, if your income exceeds expenses on a monthly basis.
If your goal is to get your home mortgage paid off, a HELOC is a great way to do it. However, it is not without some risk. The risk HELOCs pose is variable interest rates keyed to an index. Because of the rapid principal reduction in this plan, rates going up a little won’t matter much. The other risk is if the banks start calling in lines of credit like they did in the last recession. Again, this plan isn’t for everyone, but for the right situation and with proper advice from the bank and any other financial advisors, it can be an advantageous tool for building your equity.
About Duane Duggan: Duane Duggan has been a Realtor® for RE/MAX of Boulder in Colorado since 1982 and has facilitated over 2,500 transactions over his career, the vast majority from repeat and referred clients. He has been awarded two of the highest honors bestowed by RE/MAX International: the Lifetime Achievement Award and the Circle of Legends Award. Living the life of a Realtor and being immersed in real estate led to the inception of his book, REALTOR® for Life. Also see his video podcasts about real estate topics on RE/MAX of Boulder’s YouTube channel.
For questions, email Duane at DuaneDuggan@BoulderCo.com or call 303-441-5611