[00:00:00] Speaker A: A home equity line of credit is a tool that, when used appropriately, gives you a way to access some of the equity in your home without having to sell the property. In this episode, we talk about what it means to use it appropriately and how to decide whether or not you should open a heLOC based on your home's value. Let's get started.
[00:00:17] Speaker B: Let's get some money from new money new problems. It's the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles uh, they've never seen.
Negotiating compensation, purchasing your first investment property, helping your family with money, the highs and lows of entrepreneurship. New money brings new problems that require new solutions. Join us as we work through them together.
I'm Brenton Harrison, and this is the New Money New Problems podcast.
[00:00:55] Speaker A: Hello. My name is Brenton Harrison of New Money new problems and your host for the new Money New Problems podcast on. Last week, we did an episode on the different types of financial advisors. A couple weeks back, we started the process of getting into homeownership and home buying by talking about whether or not having a mortgage actually helps you with your taxes. And in this episode, I wanted to talk to you about something that I almost always recommend people put in place if they're homeowners, even if they have no intentions of using it. That is a home equity line of credit. A home equity line of credit is one of the two ways that you can access the equity in your home without having to sell the property. In a few weeks, we're going to talk about the other way, and then later down the line, we will compare and contrast the two different options. But for today, I wanted to talk to you about what a home equity line of credit is, how it works, how it's repaid, how it benefits or hurts you in different areas of your finances, and dig a little deeper into why I recommend them for so many people. So, first, what is a home equity line of credit in the first place? Well, a home equity line of credit is a line of credit that uses the equity in your home as collateral. For example, if you're following along on screen, let's say that we have a homeowner who has a home that's valued at $400,000, and the mortgage on that home is $280,000. Well, most lenders are going to look at a home, and they're going to take a certain percentage of that home's value. In most cases, you'll find that to be 80%, and they're going to subtract the mortgage balance to calculate your available line of credit. So in our example, if we take 80% of our $400,000 home value, that would be $320,000. And if we subtract our $280,000 mortgage balance, that would leave us with an available home equity line of credit of $40,000. Now, when it comes to the calculation percentage, you will find that 80% is typically the standard in normal times, but there will be times where interest rates in the general economy are higher or lower. And maybe during those periods, a, uh, lender will give you access to less of your home's loan to value, say 65 or 70 or 75%. Or there may be periods where they give you more of your home's loan to value, like 85 or 89%. You will also see that if you have a home whose value is above a certain number, that they will typically give you access to less of the home's equities. So, for example, if you looked a couple of years ago, if you had a home that was valued m below a million dollars, a lender may have given you access to up to 89% of your home's loan to value. Whereas if you had a home that was above a million dollars, they would stop you at 80%. So they're essentially saying, we don't want to have these super, uh, high priced homes in a position where the homeowners can access just these really large amounts of equity. The higher the value of your home, the less of the percentage they will give you on a home equity line of credit. And when it comes to the structure of your home equity line of credit, when it comes to repayment, when it comes to taxes and other different types of debt, it kind of straddles the fence between what we call installment debt and revolving debt. You see, installment debt is debt that you have access to for a certain period of time, ten years, 15 years, 20 years. And during that period of time, you can borrow the funds one time, and you have to pay what you've borrowed off in full by the end of the period. An example of installment debt would be a mortgage. It would be a student loan. It would be a car loan, where you buy a car for $50,000, you're repaying it over seven years. You borrow the money for that car one time, and you have to have paid off what you borrowed by the end of the seven year period. And when it comes to installment debt, you have to understand that, first, it does not impact your credit utilization. Credit utilization being an element of your FICO score that constitutes 30% of your score, but it is not impacted by what you owe on installment debt. And in addition, you will find that with many forms of installment debt pending certain things like the amount of your adjusted gross income, you can in some cases benefit from tax deductions that are associated with your installment debt. For example, if you own a home, we've talked about if you itemize your taxes, being able to deduct the interest that you pay on that mortgage. There are also scenarios where if you earn below a certain amount of money, you can deduct certain portions of your student loan payment. That's installment debt. Home equity lines of credit are like installment debt because they do not impact your credit utilization like a credit card would. But they also have a limited period of time in which you can borrow the funds, like five or ten years. Unlike installment debt, however, a home equity line of credit gives you access to that amount of money, and you can borrow the funds over and over and over again. So if you have the $40,000 line of credit, like in our example, you're not limited to borrowing it one time, you don't even have to borrow it at all. If you have an open $40,000 line of credit and you choose not to borrow the money, then you don't owe anything. But if you do borrow the money, you can borrow it, pay it down and go borrow it again. That is what it's like to be a revolving debt. And a revolving debt is like a credit card where you have, say, a $10,000 credit limit. You can borrow the $10,000, pay it off, and then go borrow the $10,000 again. Revolving debt, like a credit card, does impact your credit utilization. So if you borrow $10,000 on a $10,000 credit limit, then you have 100% utilization ratio, which would wreck your credit. And, uh, also with many forms of revolving debt, there is no limited period of time in which you can borrow the funds. If you have a credit card, unless you act adversely with that credit card, you can keep it open for the rest of your life. But as we covered with the HELOC, that's not the case. It has the installment portion in terms of how long you can borrow the funds, like with installment debt. And it has the ability to borrow the funds over and over again, like you would find with the revolving debt. You also see a similarity when it comes to installment debt with a home equity line of credit on your taxes, because you can deduct the interest that you pay on a home equity line of credit, as long as those funds are used for the improvement of your primary residence. If you're looking on screen, you're looking at a schedule a, which is where you list your itemized deductions. We covered this a few weeks back. We'll put it in the show notes, but you can see in line eight that one of the deductions that's available to you is the home mortgage and interest points. But then it says, if you didn't use all of your home mortgage loans to buy, build, or improve your home, see instructions and check this box, meaning that if you did not use the home equity line of credit for the benefit or improvement of your home, then even though you spent the money, even though you paid the interest, you cannot deduct it on your tax return. Now, how do you repay a home equity line of credit? Well, home equity line of credit is very interesting because unlike installment debt, where you have the period of time and you have to repay the principal and interest in full by the end of that period. A home equity line of credit has the period of time, but you do not have to pay off the principal and interest in some predetermined schedule over the course of the five or ten years. You see, with most home equity lines of credit, you're only required to pay the interest that's occurring on whatever you actually borrowed during that period. But you don't, uh, owe anything if you haven't borrowed on the home equity line of credit. But let's say that you borrowed 10,000 of the available 40, well, each month, you're not required to pay the amount that's needed to pay down $10,000 in principal and interest over the course of five or ten years. You're only required to pay whatever interest is accruing off the $10,000 that you borrowed. Now, that sounds great. If I borrow $10,000 and interest is 4.8% a year, that means that I only have to pay $480 of interest, which is $40 a month. And if I borrow $10,000 and only have to pay $40 a month towards it, that seems like a pretty good deal until you get to the end of the five or ten years that you have on your term. Because at the end of that five or ten years, you have three options. You either have to pay the lump sum for what is unpaid on the home equity line of credit. You have to refinance the underlying mortgage to roll in the amount that you've borrowed under the home equity line of credit, or you have to ask for an extension. So let's focus on option one. If you have not shown the discipline to pay the principal and interest over that period of time, then you could be in a rough shape. You have to come up with some, in our case, $10,000 lump payment that you may not be in a position to make. Option two can be equally disadvantaged if you have an interest rate on your current mortgage that is lower than what's available in the current marketplace. So, for example, let's go back to our scenario where we have this person who has a $280,000 mortgage. If that $280,000 mortgage is something that they got in 2021 at 2.5%, and they had to roll in the amount and refinance this current mortgage to include the $10,000 that they borrowed on the home equity line of credit, then now they'll go from owing 280 to 290. But not only will they do that, they'll go from owing 280 at 2.5% to $290,000 at whatever current interest rates may be. And we all know that rates are no longer at 2.5%. And when it comes to the extension, in times of economic stability, this may be something that's fairly easy to do, to just go and say, hey, I want another five years, another ten years. But in times of economic instability, your lender may be less likely to offer you that extension, and they may require you to take advantage of option one or option two. And now that you know how a HELOC works, after the break, we'll tell you some common ways that people use these home equity lines of credit, and I'll tell you why. I typically recommend people put them in place, even if they have no intention of using it moving forward.
[00:10:48] Speaker C: This is the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen. We'll be right back.
[00:11:06] Speaker B: Are you wondering what new money problems you might be overlooking in your financial life? If so, we've got great news.
We've crafted the new money new problems gap finder to identify potential weaknesses in your finances in areas ranging from budgeting, investments, insurance, and even the threat your extended family's finances could pose to your household. Please head to newmoneynewproblems.com gapfinder to complete it today. Again, that's newmoneynewproblems.com gapfinder to take the assessment.
[00:11:45] Speaker C: You're listening to the new Money New Problems podcast. Subscribe
[email protected]. Welcome back.
[00:11:56] Speaker A: Before the break, we talked about the structure of home equity lines of credit, and now I want to talk about the three most common uses that I see amongst clients and just people that I come across in my daily life. The first use that I see for a home equity line of credit is one that I actually disagree with the most. Odly enough, it's the only way that you can take a tax deduction for the amount that you've used on your home equity line of credit, and that is the actual repair or renovations of your current residence. So, for example, if you're going to redo your bathroom or redo your kitchen, you can access your home equity line of credit for those things, and you can deduct the interest that you pay on an ongoing period. Now, if it's something that you do not have the emergency funds to do, or there's some m uh, interest rate advantage that you get for doing so, which in many cases there's not. Because if it's for something like a roof, you can often get something where it's a low interest or a 0% interest period for a certain period of time by actually doing the financing with the company that's replacing the roof. But when I see people doing this for home upgrades, I'm very, very wary because it's different if you have to do something, but if you're doing something for cosmetic or aesthetic reasons. One of the things I found, not just as a financial advisor, but as the son of a realtor who has looked at the end value of those properties, is that in many cases, it does not do much for the end value after the renovation. When you do that type of repair upgrade, as a matter of fact, it may not add any value at all because plenty of people will come into a previously existing home and want to make their own repairs and renovations to make it look the way they want it to look and not the way you want it to look. You find this with people who use home equity lines of credit to do things like build a pool. And one of the things that you find is that you very rarely get the money back from building a pool. If you wanted a pool in your backyard, you'd actually be better off just buying a house that already had a pool. But if you are planning to use a home equity line of credit for repairs and upgrades, I would highly advise you to do it under the consultation of a realtor who can give you an idea of what actually adds value after the process is completed on a home. And if you're doing something that requires multiple elements, like bathrooms and kitchens and redoing bedrooms, then I would also seek a general contractor. So that instead of having three or four different vendors and contractors coming into your home with no cohesive plan, you have a general contractor who's overseeing the project to make sure that it's cohesive and coordinated, and that the end result is actually something that will benefit you financially. The second way that I see people using home equity line of credits in a way that I do agree with, in many cases, if there is the discipline to repay the principal and the interest is to use the HELOC to pay off credit card debt, this can help you in several different ways. Remember, at the first half of this episode, we mentioned the fact that a home equity line of credit does not impact your credit utilization, even though you can borrow the money over and over again. Well, that's beneficial because let's say, for example, that you use $10,000 from your HELOC to pay off $10,000 on a credit card whose utilization ratio was crazy high. Well, what you've done is you've just shifted the $10,000. You don't, uh, owe any less after the transaction than you did before the transaction, but you've paid off a credit card that does impact your credit utilization, and the HELOC does not. So even though you owe the same amount, it has effectively disappeared when it comes to calculating your credit utilization. This can immediately lead to a large increase in credit scores. And if this is something that you're doing before applying for other forms of financing, it can actually help you in the long term by not only putting that debt at a lower interest rate, because a HELOC is typically a significantly lower rate than a credit card by positioning to a place that doesn't impact credit utilization. And then if you're going to apply for new financing, you will likely get better interest and better terms on the new financing because of that improved credit score. So that can have some really beneficial impacts as long as you have the discipline of understanding. Even though I only have to pay the interest, I need to, whenever available, make lump sum payments on the principal as well, so that I don't owe this at the end of the period. And then lastly, investment properties. And we're not going to spend a ton of time on this because we're going to dedicate more time to it in future episodes. But I often see people with equity in their primary home. Who will use a home equity line of credit to put a down payment on an investment property. And it's very difficult to come up with a down payment for an investment property because unlike with a primary home, where you can put as little as three and a half percent down if you're a first time home buyer, 0% down if you're eligible for things like the VA loan. Most lenders require a full 20% down payment if it's for an investment property. Some lenders require 25% to get the most favorable terms on that new mortgage. So it's not as easy to come up or part with that money, even if you do have it in your savings or in an investment account. So people will use the home equity line of credit, and then they will position themselves so that the tenant in that investment property can pay not only the mortgage on the property, but also the principal and interest on the home equity line of credit. This is something that can be a really positive way to access investment properties, but only if you have the ability to calculate the spread that you'll get on what you're charging on rent on that home, and also what you're owing on the mortgage and what's needed to pay down the principal on the home equity line of credit. You see, what I see in many cases when people do this is they're charging enough in rent to pay off their mortgage and pay the interest that's due on the HELOC, but not enough to pay down m the principal as well. And as home values get higher and as we get priced and priced out of more cities, it's becoming more and more difficult to get a big enough spread on the two to actually have this make sense. And the people who I see it most likely working out for are people who are buying investment properties in cities that are not your Nashville's, they're not your Miami's, they're not your Dallas's, where people are flocking to them. It's people who are buying property in Zanesville, Ohio, or people who are buying property in some small town America, where there's still the availability of getting a reasonably affordable property, but charging enough in rent, where you have a tenant who can make a difference between the two, that allows you to use your leverage, your equity in the home and the rent that you're charging them to essentially have your tenant pay down the investment in that second property for you. And if you're looking at this and you're wondering, why does Brenton recommend that people get these helocs even if they have no plan to use them. It's because of that element I mentioned where if you don't borrow money on the Heloc, you do not owe money on the Heloc. And even if you do, it does not impact the credit utilization of your FICO credit score. So to me, the flexibility that comes with helocs and the options that it gives you for things like repurposing debt, or even, in a proper scenario, using it to fund different investments like investment property, or even funding elements of your business before you're eligible for pure business financing. I would rather take the concept of a HELOC being something that you would rather have and not need than need and not have, which is why I recommend it for so many of my clients. In a couple of weeks, we're going to talk about the second way that you can access the equity in your home without selling it. And down the line, we'll compare the pros and the cons of each option.
[00:19:17] Speaker B: From new money new problems. This was the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen.
Let's get the money.
