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Home Equity Line of Credit Part III

During the past two segments we have introduced the concept of a home equity line of credit and whether we should retire the line of credit if we have the cash or are refinancing. This segment we would like to conclude our three-part series by looking at the Home Equity Line of Credit (HELOC) in terms of helping finance a home purchase. There are several uses of a HELOC with regard to this situation–

1. Lessen the cash necessary for purchase without incurring mortgage
insurance charges.
2. Lower the first mortgage amount so that you can achieve a lower “conforming”
mortgage rate.
3. Have cash in reserve even though you have used your capital for the home

So, let’s look at each of these individually. The first involves the elimination of mortgage insurance. Here are three common alternatives with “hypothetical” rates–

  • 5.0% first mortgage with .68% mortgage insurance.

  • 5.75% first mortgage with no mortgage insurance.

  • 5.0% first mortgage and an 7.0% second mortgage.

In the last segment we introduced the concept of a “weighted” average so you could compare debt consolidation refinances. (If you did not receive this article, contact us). You can see that this calculation will apply in this comparison as well. However, there are additional considerations here–

  • Mortgage insurance may not be deductible from your income taxes, while the
    mortgage payment is. Therefore, the 5.75% may have a lower effective rate
    than 5.0% + .68% when your tax bracket is taken into consideration.

  • Mortgage insurance can be cancelled within two to five years, depending upon
    the future value of the home. Therefore, you might wind up making mortgage
    insurance payments for two to five years, but higher mortgage payments for a
    longer time period.

  • The HELOC may be an adjustable rate that can increase in the future, while
    mortgage insurance will remain the same in the future.

The second decision, avoiding a higher rate for a “jumbo” vs. “conforming” mortgage involves some of the same comparisons and considerations. A conforming mortgage is one that can be purchased by Freddie Mac or Fannie Mae. Let’s say for sake of comparison, the conforming limit is $525,000.

  • A 5.0% first mortgage with an 8.0% second. ($625K + $100K)

  • A 5.50% first mortgage ($725K)

Once again the weighted average must be considered. Generally, the larger the second compared to the first, the more likely the HELOC option will be more costly. It should be noted that the tax bracket is not an issue here because mortgage insurance is not being paid in either case. However, it should also be noted that this option can be combined with the first set of choices to both eliminate mortgage insurance and achieve a conforming rate.  Note that this example, as all in this article, is hypothetical – the “spread” between conforming and jumbo mortgages will change and sometimes jumbo rates are lower than conforming rates.

The third choice sets the HELOC apart from “closed-ended” second mortgages, which is a loan that you pay down each month, but you cannot borrow more money without obtaining another loan. The HELOC is “open-ended” which means that you can always borrow more money as long as you don’t exceed the maximum HELOC amount. In other words, if the HELOC starts at $50,000 and you pay $5,000 off, you can borrow that $5,000 back in the future.

Therefore, if you have $100,000 in the bank and you don’t know whether you should put that money down on the house or save it for a rainy day, you can put the money down and take out a HELOC but not use the balance. If there is an emergency, you can access the HELOC to serve the purpose of emergency cash. You are forgoing interest you would earn at the bank–but also be paying interest on a smaller mortgage.