Paying off your debts using an acceleration method like the debt snowball or avalanche method can do wonders for your cash flow. But squeezing your budget to come up with the extra funding you’ll need can sometimes be challenging.
In this post, I’d like to introduce you to an income source that you may not have considered. If you’re a homeowner and have been making your payments for some time now, then chances are good that you’d be able to qualify to apply for what’s known as a HELOC.
What is a HELOC?
A HELOC or home equity line of credit is a type of loan arrangement that allows homeowners to borrow against their equity.
Unlike a traditional home equity loan where the lender writes you a check for the lump sum amount that you need, a HELOC works more like a credit card. You can borrow whenever you need and as much as you need as long as you don’t exceed the limit set by the lender.
How Does a HELOC Work?
Basically, there are two phases to a HELOC: the draw-down period and the repayment period.
This is where you’re allowed to borrow money from the HELOC. There won’t be any payments due on your principal, but you will have to make minimum monthly payments on the interest (which will be a variable interest rate). The draw-down period usually lasts for about 10 years.
This is when you’ll no longer be able to borrow against the HELOC and it’s time to start paying them back. Essentially, your outstanding balance will be converted into a traditional fixed interest loan where you’ll make regular payments back to the lender. The repayment period usually lasts for about 20 years.
Note that even though you don’t have to pay back the principal during the draw-down period, it may be in your best interest to do so if you can. The lower your outstanding balance is going into the repayment period, the lower your payments will be once the HELOC closes.
How a HELOC Can Help You with Debt?
When you’ve got debt that you’d like to repay (such as high-interest credit cards or student loans), usually the issue is coming up with extra funding. You might save and sacrifice as much you can, but what if you need a little extra to really accelerate the process and pay down your debt as quickly as possible?
This is where a HELOC can be helpful. There can be a lot of advantages to using a HELOC over other types of loans to reduce your debt. Here are some of the benefits to consider.
Interest Rate Reduction
As Christopher Liew from the site Wealth Awesome points out, HELOCs have much lower rates than your other credit lines.
For instance, the average interest rate on credit card loans is 20.47%. Meanwhile, the average interest rate for a $50,000 loan on HELOC is an average of 4.14%. That gap of 16% could translate into some major savings, especially when it may have taken you years to pay it off.
Ease of Qualification
If you need a loan for a new business, then you may find it difficult to get the funding you need. Lenders will want to see detailed business plans and financial forecasts that will demonstrate your new business will be successful. If they suspect that it won’t be, then you may not get approved for the money you need.
By contrast, since your home is a tangible asset, most lenders will have no problem allowing you to tap into the equity. That can make the process much easier.
Potential Tax Deductibility
Another great benefit of HELOCs is that they may qualify as tax-deductible. Mayer Dallal of MBANC reminds us that the interest can be taken as a tax deduction if the loan is used for home improvement. And with interest rates at their current low levels, there are good deals to be had.
Just like a regular home equity loan, you’ll need to itemize your deductions when you file your federal tax return in order to make this interest count. Just be sure you can prove that the loan meets the IRS requirement of being used to “buy, build or substantially improve a taxpayer’s home that secures the loan”.
How to Get a HELOC
Getting a HELOC is a relatively straightforward process. You can even apply online.
Austin Fain from Perfect Steel Solutions explains that to fill out the application, you’ll need to prove:
- Your equity in the house (at least 20 percent)
- The estimated value of your property
- Tax returns etc.
Your lender might also ask for information such as bank statements or other loan payments. Your chances of qualifying will be better if you have a higher credit score and low debt to income ratio.
The process is not difficult, but it does take time. Be sure to give it at least 3 to 4 weeks to get through underwriting.
A Word of Caution
While a HELOC can be a strategic way to pay off your existing debts, it’s not an end-game solution. As Kristine Stevenson Seale from Advocate Financial Coaching points out, you’re essentially trading one type of debt for another.
Another danger you need to consider about a HELOC is that you’re putting your home up for collateral. That means if for whatever reason you’re ever not able to repay the money you’ve borrowed, then you could risk going into foreclosure and losing your home. This is why it will be very important that you weigh the pros and cons of using this strategy carefully.
Once your debts are paid off, don’t fall into bad habits. If you’re using your HELOC to get out of debt, then make sure you keep your slate clean and don’t open any new loans now that your old ones have been paid off.
How Much Will My HELOC Payments Be?
If you’d like to get some idea of how much your HELOC payments might be, then try out a free online calculator like this one here. Compare that to what you’re currently paying on your other debts and determine if borrowing against your equity makes sense.
Of course, even if you’re only making just payments on the interest, you’ll still want to guarantee that a HELOC will fit into your budget. To help you determine this, use a budgeting app like Buxfer to layout your monthly expenses and see how much you can afford. In addition, you can also use Buxfer to get some idea of how much your budget will change once your outstanding debts are paid off.
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