In the last segment, we discussed the characteristics of a typical Home Equity Line of Credit (HELOC). A typical HELOC is a second mortgage, an open line of credit that can be used to access capital and will typically have an adjustable rate. The next question is–should you procure a new HELOC or retire the HELOC you already have?
Let’s first talk about the retirement decision. There are two ways to “retire,” or pay off a HELOC. The first method would be to use cash to pay the balance off. This will certainly be rarer than the other method, represented by refinancing or consolidating both mortgages into a new first mortgage.
It makes sense that you obtained a HELOC because you needed cash either to purchase a home or consolidate debts. If you borrowed $50,000, most people do not have $50,000 at their disposal to pay the HELOC off. After all, in America we have the lowest savings rate of any industrialized country in the world.
But let’s say you do have the money. Should you use that money in a different way or should you use it to pay off the HELOC? In one respect this is a difficult decision because we don’t know two things–
1. What the rate will be on the HELOC in the future (if it is an adjustable rate mortgage);
2. What the return on investment will be on the money being utilized in another way.
In this case we will simplify the analysis with the assumption that the HELOC is either a fixed rate or will stay fixed in the near future. Let’s say you are paying 4.50% on this HELOC. The important thing we need to get you to understand is that it is not the interest rate that is important, but the rate you pay after taxes.
Assuming a tax bracket of 33.0%, the homeowner would be paying approximately 3.00% after taxes–if the HELOC is deductible. Keep in mind that mortgages are deductible only if obtained to purchase or improve property and you should consult a tax expert for advice in this regard.
So, the question is, would you earn more than 3.00% after taxes on your money? That is a pretty good rate of return for fixed returns. Certainly higher than banks and when you get into stocks, bonds or real estate, this brings us to the element of uncertainty.
There are psychological issues as well. Would you be more comfortable with cash reserves or with equity in your home? How much risk are you willing to assume when you invest the money?
While the first method of retirement was interesting, the second method is actually going to happen more often. More often than not, you will retire a HELOC by combining it with a new and larger first mortgage through refinancing.
For example, let us say that you owe $200,000 on a first at 5.0%. And you have a HELOC at 7.0%. You can get a new first mortgage at 5.25%, but would you be better off?
The weighted average of your first and second mortgage is 5.4%. Therefore, even though you would be raising the rate on your first mortgage, the overall rate would be lower. There may be other factors at work here–
•The convenience of making one payment instead of two.
•The first mortgage may be a fixed rate and the HELOC may be an adjustable, which means that you could be subject to future rate increases.
You may use the same transaction to access additional equity in the house and use this to pay off additional debts. Of course, this is a separate analysis in which you weigh the new lower payment against stretching out the payments on these debts.
There are some interesting considerations here. In the next segment we will look at the purchase decision.
