Housing & Mortgage
Got Discipline? A Home Equity Line Could Bolster Your Financial Defenses
Used smartly, a small portion of your home equity can be a backup emergency fund
Recent swings in the stock market could be early signs that the economic expansion, nearly 10 years old now, is finally winding down. Short-term interest rates are getting dangerously close to the level of long-term rates. That can signal a recession in the offing. Trade wars don’t help matters; as Apple’s recent earnings warning in early January suggests, a sneeze in China can be the flu for corporate America.
That’s not to suggest that a recession is around the corner. Economic growth continues and unemployment is below 4%. Rather, what’s new is that after years of being out of the question, recession is back on the radar screen.
That makes this a moment of significant opportunity to build financial defenses. Having a home equity line of credit, or HELOC, in your back pocket as a complement to your emergency savings fund is a smart way to buy yourself some insurance if your household gets thrown off balance by a job loss in the next recession.
Why now is a good time to apply for a HELOC
As the graphic below shows, home prices have been on a tear.
Even if you bought a home recently with a low-down payment , you may now have more than 20% to 25% equity. That gets you past the first hurdle in qualifying for a HELOC. And though home price gains are expected to slow a bit this year, the expectation is for inflation-beating gains on average. Combine that with a still-solid economic outlook and it’s likely that banks and credit unions should remain in a lending mood.
Most important, the time to apply for a HELOC is when you don’t need it. Wait until a recession hits and you’re downsized, and you will be hard-pressed to get a HELOC lender to say yes.
To be clear, a HELOC is not a substitute for cold-hard cash savings. Nor can you get a good deal with an iffy financial profile. Here’s how to build a HELOC into a sound financial plan.
Don’t shirk your emergency savings. There is no substitute for having a dedicated emergency savings fund in place to give your household the ability to weather a layoff, or reduced revenue for entrepreneurs.
Six months of living expenses in a bank savings account is a decent baseline. But if you know you’re in a vulnerable position, or in a vulnerable field, you might want to increase that to close to a year. Among people laid off during the last recession, the average time it took to land a new job stretched to 29 weeks. For workers between the age of 55-64 it took a year.
If you don’t want to – or can’t – come up with that big a savings fund pronto, a HELOC can help you increase your reserves. One way to think about this is to have dedicated savings that cover six months of living expenses and then access to a HELOC that could be used if you run through those savings.
A HELOC isn’t a sure thing. During the last recession, with home prices plummeting and bank balance sheets wobbling, many banks froze or reduced HELOC lines. That was during a severe financial crisis. And the situation was exacerbated by the fact that lenders had given HELOCs to homeowners with no equity. That’s not in play these days. You typically need to have at least 15% to 20% equity to get a HELOC.
While that suggests banks may not feel as pressured to freeze/close lines in the next recession, the safe takeaway is to not think of a HELOC as a primary emergency fund, but as a backup.
Save your HELOC for true emergencies. A danger with opening a HELOC is the temptation to use it for indulgences. Look, you know yourself best. If you think you will be tempted to tap your home equity for a nice vacation, or a tricked-out luxury car, maybe this isn’t the right strategy for you. Instead, vow to open a relatively small line of credit. Even if a bank or credit union is willing to give you a $100,000 line, maybe you limit yourself to $25,000 or $50,000 to limit any potential damage.
Make sure you’re looking financially fetching. Your FICO credit score is going to come into play when you apply for a HELOC. The best terms are reserved for borrowers with credit scores of 740 or higher. Lenders will also want your combined monthly debt payments to be less than 43% or so of your monthly income. (That can vary by lender, by your FICO score, and your equity).
Understand the (variable) terms. HELOCs are typically variable-rate loans. In a recession, that might work to your advantage, as interest rates tend to fall when the economy is weak. But if you tap your HELOC, you have to think about how long it will take you to repay what you’ve borrowed. You typically can just make interest payments during the first 10 years (called the draw period), and then you must repay interest and principal over the next 10 to 15 years. That exposes you to the risk of rising interest rates as the economy grows. A hybrid version of HELOCs allows you to lock in a fixed rate once you use some of your HELOC. Just be careful you understand how that fixed rate is calculated. Lenders can charge whatever they lay out in the fine print of your original loan document.