fbpx

What is a HELOC and How Does It Work?

When you purchase a home, you most likely purchased it using a standard mortgage. You put a percentage down – somewhere usually between 3.5 and 20% and you pay the mortgage every month trying not to think too hard about the amortization schedule.

That’s the traditional avenue – a standard mortgage paid off over 15 to 30 years. But there is so much more opportunity in purchasing a home and leveraging its value. There are all sorts of ways to finance a home, get equity out of a home, and access liquidity for other opportunities.

A home and a 401(k) are the two biggest stores of wealth for most people but they are also the two biggest reasons most people struggle to find money for investment outside of those two instruments. The mortgage and the 401(k) tie up your liquidity.

This is where a home equity line of credit (HELOC) can come in handy. A HELOC is like a low-interest credit card that allows you to access some of the equity you have built up in your home. You may also have heard a HELOC referred to as a “second mortgage.” Interest rates on a HELOC run a bit higher than the traditional mortgage rate but much lower than credit card interest rates.

There are two types of HELOCs. One is more of a fixed loan you take out all at once. The other is a more flexible line of credit you can draw from repeatedly as long as you can cover the monthly repayments. Those payment amounts will fluctuate depending on how much you have drawn out at any given time.

We prefer the one you can use over and over for several reasons.

For one thing, in a previous article, we talked about the four main attributes of money: Liquidity, safety, taxes, and return. A HELOC helps with that first attribute, liquidity, in a way a traditional mortgage cannot. It allows you to access funds and be more liquid to seize opportunities, to consolidate high-interest debt, or to help a family member in need.

Another advantage of a HELOC is that it is not amortized like a traditional 30-year mortgage. Most of us know that if you buy that proverbial $250,000 house and you take 30 years to pay it off, you are actually spending double or more for that property. Plus you are spending money on routine maintenance and updating the home for safety, comfort, and appeal over three decades.

When you consider that most people move every 5-7 years, it’s no wonder more than 60% of people in their sixties or older don’t have their mortgage paid off. Of course, a popular tenant in financial planning is to tackle debt first. Get rid of it. But even when people believe in this principle, that mortgage is just too daunting to tackle. It’s a catch-22 because people want to pay off debt, but their liquidity is tied up in that mortgage!

A big part of what we teach people is the power of getting more of your monthly cash-flow to do one thing instead of 10. If you can get more of your monthly cash-flow to go towards your HELOC and pay it back faster, that’s a big win for you. And because it isn’t amortized you can pay down principal on your mortgage faster, but still, have access to funds through your HELOC when you need it.

I recently wrote about the quandary of whether to pay off debt or invest first. A HELOC gives you the potential to pay off your home faster, but still have access to the equity when you need it. We think this is a great way to leverage your liquidity and begin to clear a path for making investments when opportunities present themselves.