Sounding like a character out of Game of Thrones, a HELOC, which stands for Home Equity Line of Credit, is a popular consumer lending vehicle designed for U.S. homeowners. While the Tax Cuts and Jobs Act of 2017 dealt a blow to HELOCs by curtailing their tax deductibility, they remain a compelling and viable cash financing source under the right circumstances.
Using your Home as Collateral
Since HELOCs are, in effect, a secured loan against the equity in a home, HELOCs can serve as a more attractive funding source than credit cards and other forms of unsecured loans. Homeowners figured that out during the pre-financial crisis housing boom as homes were essentially used as ATMs. With the recovery in home prices over the last several years, HELOCs are regaining popularity as shown in the chart below.
HELOC terms will vary by lender and are impacted by the home’s appraised value, the amount of home equity, borrower’s credit score, and household income as it relates to total debt.
An Attractive Financing Option
HELOCs offer several potential benefits to homeowners in need of funds:
- Significant Capacity – Depending on the amount of the homeowner’s first mortgage, a HELOC can offer significant borrowing capacity. Generally, the primary mortgage plus the HELOC may be 80%-90% of the appraised value of the home. So, if a home is worth $1 million and has a primary mortgage of $500,000, the homeowner could potentially borrow up to $300,000-$400,000 on a HELOC.
- Low Cost and Attractive Rates – Since HELOCs are secured by appraised real estate, interest rates (which are typically tied to the prime rate) are significantly lower than with unsecured loans such as credit cards. Other than the appraisal fee (which may be waived by the lender), HELOCs have little to no set-up fees or origination fees.
- Convenience – HELOCs are a a line of credit, meaning the borrower can draw down and repay the funds as needed once the loan is set up (typically takes several weeks to process). Some lenders may set a term or require an amortization schedule.
- Flexibility – HELOCs can be used for home renovations, debt consolidation, college education, emergency funds, bridge loans, etc. However, this flexibility can also be a negative given the potential for homeowners to spend their loan proceeds on discretionary items.
But, what about that Interest Deduction?
Up until 2018, homeowners could deduct the interest on up to $100,000 of a home equity loan while using the proceeds for just about anything. However, as a result of the new tax code, there are several reasons why it will be more difficult to get that deduction.
First, given the new, higher standard deduction levels ($24k for a married couple) it will be harder for households to reach the level where they will itemize deductions, including primary mortgage as well as HELOC interest. Second, HELOC interest will only be deductible if the borrowed funds are used as “acquisition indebtedness.” This includes “indebtedness that is secured by the residence and that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.” In other words, deductions on loans used for something other than for home renovations are eliminated. Lastly, deductible interest on new primary and second mortgages will be capped at $750,000 (down from the $1.1 million). Taken together, there will be fewer household that will deduct interest.
How to Evaluate
Despite the more elusive interest deduction, HELOCs will likely remain an attractive option for those needing access to funds. Furthermore, it’s always better to set up a HELOC in advance of needing one. It may be difficult or impossible to qualify for a HELOC if you are not employed, which is when you might need one the most. With that being said, while it is good to consider setting one up, one should think carefully before drawing down the line. As with any loan, borrowers should make sure they have a clear path to repayment. SMS can help evaluate the use of a HELOC as part of a household’s overall financial picture. Moreover, a tax advisor should be consulted to determine deductibility of interest.