With this type of variable-rate loan, homeowners can draw money at their discretion. However, in an effort to lower their risks in making the loans, banks have instituted some restrictions.
First, getting a HELOC typically requires a credit score North of 700. As with access to credit in other formats, a good credit score is essential. Second, many banks have instituted curtailment clauses. Essentially, this means that the bank can cut off your access to the line of credit at their discretion.
And finally, the amount of money the bank will allow you to borrow against your home will likely be limited to an amount based on a loan-to-value ratio of around 80%. As an example, if your home is appraised at $270,000 and the balance of your loan is $210,000, the maximum loan you could get would be $6,000: 270,000 x .80 = 216,000 – 210,000 = 6,000.
Recently, the rates on these loans are averaging below 5%. Why might you consider taking out a HELOC? Banks pitch them as tools to be used in the same way people typically use credit: to pay for a child’s education (discussed here), to make home improvements, to consolidate other debt – particularly credit card debt – and as the source of an emergency fund. Of course, regular readers of this blog know that I am a fan of a traditional emergency fund. Just as I have suggested using credit cards as an emergency fund is a bad idea, so is using a HELOC as an emergency fund.
As noted previously, the bank could limit access to your HELOC at their discretion. Nothing worse than believing you will have access to money when the unexpected occurs, only to find out that your access has been limited or completely cut off. You are much better off maintaining a true emergency fund which you control.
While there are probably worse things in the world than HELOCs, they are probably best avoided by savvy retirement planners. Need an emergency fund? Establish and build one at a bank or credit union. Want to send your child to college? Start saving early and look at options such as a 529 College Savings Plan. Use a HELOC as a consolidation loan? You’re better off putting yourself in a position (i.e. avoiding credit card debt) where you don’t require one.