If your emergency funds could use a boost, consider heading home.
A home equity line of credit — a loan that is secured by your abode — could act as an emergency source of cash in a pinch, as long as you use it responsibly.
“The one good thing about HELOCs is that the interest is at a better rate than what you’d get on personal loans and credit cards,” said certified financial planner Douglas Boneparth, president of Bone Fide Wealth in New York.
Indeed, interest rates on HELOCs are currently in the range of 4.25 percent to 6 percent, according to Lending Tree. Meanwhile, average credit card interest rates are hovering around 17 percent and personal loans can carry rates exceeding 6 percent, according to Bankrate.com.
“It’s an attractive rate compared to other credit products, and it’s relatively easy to get if you have decent credit,” Boneparth said.
About a quarter of homeowners who’ve taken out a HELOC have opened the line to address emergency expenses, including car repairs and medical expenses, according to a survey from NerdWallet.
The personal finance site, in collaboration with Harris Poll, surveyed 2,043 adults online in March.
Approximately 1 in 8 borrowers took out a HELOC to protect themselves in the event of unemployment, NerdWallet found.
Here’s what you should know if you’re planning on tapping your home equity to bolster your reserves.
Don’t just go to the lender that provided you with your mortgage. Instead, search for competitive interest rates, which are generally adjustable.
Some lenders also offer a hybrid HELOC, which will allow you to set aside a portion of the loan for a specific purpose and peg a fixed rate of interest to the amount borrowed, said Holden Lewis, a mortgage analyst for NerdWallet.
Under this arrangement, you’re expected to pay off that slice of the loan within a specified number of years.
Be aware that there’s more to your loan than just the interest rate.
For instance, banks can slap on a variety of fees, including charges for not using the line of credit, annual costs and lender expenses.
Some HELOCs also require that you draw down from your line of credit immediately or they may require that you maintain a revolving balance on the line for a specified time period, said Lewis of NerdWallet.
Keep this in mind as you shop around for loans and consider the purpose of your HELOC.
“Open a line of credit that won’t charge you interest unless you use it, one that won’t charge you an annual fee or only a nominal fee where you are willing to pay for flexibility,” said Boneparth.
Before you take out a loan, consider how the repayment will fit in with your cash flow if you start using the credit.
HELOCs generally have two phases: The draw period — the time during which you can pull money from the line of credit — and the repayment period.
Often the draw period is about 10 years, according to Lewis of NerdWallet. In that time, homeowners may make minimum interest-only payments.
This means those borrowers could be in for a nasty surprise at the end of the draw period.
In this case, monthly payments will jump sharply as you begin covering interest and principal on the amount you’ve borrowed.
“Any kind of credit instrument, when used responsibly, can be a helpful tool,” said Boneparth of Bone Fide Wealth. “When it’s used in an irresponsible way, it’s the stuff of horror stories.”
Be mindful of your debt-to-income ratio and how a steep increase in HELOC repayments will affect your cash flow.
The rule of thumb is that no more than 36 percent of your monthly gross income should be going toward debt repayment, including credit cards, your mortgage and other loans.
Finally, if you’re using your HELOC for reasons other than replacing your roof or gutting your kitchen, be aware that you will likely miss out on a tax break.
Prior to the Tax Cuts and Jobs Act, you were able to deduct the interest paid on up to $100,000 of home equity lines of credit and home equity loans, regardless of how you used the cash.
Now, you can deduct the interest only if you’re using the loan to improve your home.
Starting in 2018, taxpayers may only deduct interest on up to $750,000 of qualified residence loans. This applies to the combined amount of loans you're using to buy, build or substantially improve your home — this includes your mortgage and your HELOC.
“The rules of conventional thought are to avoid taking out more than you need, and to keep in mind the tax law’s changes and your ability to deduct the interest,” said Boneparth.
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