The Federal Reserve Bank of New York recently published the 2nd quarter Household Debt and Credit Report. For the fifth straight quarter, the report shows an increase in the use of Home Equity Lines of Credit (HELOC). The rise in usage could be the result of consumers feeling more pressure from high inflation and already being heavily reliant on credit cards. Despite the reason behind the increase, consumers considering the use of a HELOC must understand all aspects of this type of credit before using it.
Understanding the HELOC
When comparing HELOCs to other forms of credit, it is essential to note that the interest rate is variable and typically based on the prime rate (Fed Funds rate plus 3%). Over the last year, the Fed Funds rate rose considerably and is now at 5.5%. Therefore, the prime rate and interest rate on most HELOCs is around 8.5%. Additionally, most lending institutions limit how much you can borrow on your HELOC to 80% of your home’s current equity. For instance, assume the current value of your home is $500k, and you have $400k in home equity. In this example, you may be able to borrow up to 80% of the $400k, which is $320k.
Appropriate Uses of the HELOC
HELOCs may provide much-needed liquidity and optionality but may not be ideal in all situations. The following are common scenarios where HELOCs may be a good option:
- Emergency liquidity: In an emergency, you can use a HELOC for urgent liquidity purposes or as a supplement to your emergency cash reserve. Many households struggle to build a sufficient emergency cash reserve that covers 3-6 months of their cash flow needs. A HELOC can be a potential solution.
- Pay Off Other High-Interest Debt: If you have outstanding high-interest debt, such as credit card debt, at 20% or higher, a HELOC could be beneficial. It would allow you to trade the higher-interest debt for lower-interest debt.
- Home Remodels: When considering remodeling your home, using a HELOC may be a good option because it allows you to avoid banking fees that come with construction loans. Additionally, if used for home improvements, the interest on a HELOC is tax deductible up to the current limit of $750k, which includes any existing debt on your primary mortgage. It is important to note that the loan limit on HELOCs opened before December 15, 2017, is $1 million.
- Short-Term Financing: If cash is needed for quick/short-term financing, a HELOC can be used for negotiating leverage.
**IMPORTANT** The HELOC should NEVER be used for frivolous spending!
Because every individual has different needs and unique circumstances, it is crucial to seek the advice and counsel of a Certified Financial Planner™ when deciding whether a HELOC is suitable for you.
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Marshall Clay CFP, J.D., is a Partner and Senior Advisor at The Welch Group, LLC, specializing in providing Fee-Only investment management and financial advice to families throughout the United States. Marshall is a graduate of the United States Military Academy in West Point, New York, the Cumberland School of Law in Birmingham, Alabama, and is a CERTIFIED FINANCIAL PLANNER™. In addition, Marshall is a frequent guest on local television stations as an expert on various financial planning matters.
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