August, 2007
Think it’s Time to Tap Your HELOC for an Investment? Get Some Advice First
In order for you to use a home equity line of credit effectively, quite a few things need to go your way. There’s plenty of risk in plowing borrowed money into investments that may suddenly lose their value. While home equity loan interest rates may cost you less than borrowing from your investment brokerage firm by purchasing investments in a margin account, you still need to be very careful.
To borrow home equity effectively, you need the stable interest rates and rising home values that go with a strong economy. If those aren’t present, you could easily get into financial hot water. Remember that mortgage professionals are not investment professionals or financial planners – they’ll always encourage you to borrow if you have the flexibility to do so. For balanced advice, you should also consult a financial planner.
In fact, most planners would tell you that if you need to borrow from home equity, you’re probably not in the strongest financial position to be making an investment in the first place.
It makes sense to go over a few home equity borrowing basics. There are two primary kinds of home equity debt. A home equity loan is a one-time, lump sum that is paid off over a particular amount of time with a fixed rate and number of payments. A home equity line of credit (also known as a HELOC), works more like a credit card because it has a revolving balance – interest is due on the outstanding balance and that rate may vary over time.
Here are the things you should discuss with a trusted financial adviser before you tap home equity to invest in real estate, securities, a new business, or any other form of investment.
• Will your investment deliver a greater after-tax return than you’ll be paying for the loan on an after-tax basis?
• Does your home equity loan or line carry an adjustable rate? If so, a jump in interest rates may make what you owe even more expensive and offset any gains you make in your investment. If rates fall, it’s good news, but given current conditions, it makes sense to be cautious.
• How much is property appreciating each year in your neighborhood on average? Is it enough to further offset the cost of your investment? Keep in mind that no one is predicting the double-digit property appreciation that took place in some housing markets prior to 2004.
• How will this loan work for you from a tax perspective? Keep in mind that home equity loans over $100,000 are generally not tax-deductible.
• What if you need your home equity borrowing power later for an emergency? Could you handle that emergency if your borrowing was strained to the maximum?
• How liquid is this investment? If you had a sudden major expense or lost your job, could you turn it into cash without major hardship?
• How are your other debts? Do you have significant balances on credit card or auto debt? That could raise the rate you pay on your loan – another potential cut in your investment profit potential. As long as you can deduct the interest, you might just be better off consolidating and paying off debt rather than taking a flyer on an investment.
• How close are you to retirement? From a cash flow perspective, will you be able to handle the loan payments if your investment using the home-equity funds doesn’t work out?
Home equity is a good option for many important financial goals, but you have to balance risk against potential reward. In most cases, it’s always good to hold home equity in reserve for a true rainy day.
August 2007 This column is produced by the Financial Planning Association, the membership organization for the financial planning community. It has been modified and is provided by Thomas A. Fisher, a local member of the FPA.
The material presented is believed to be from reliable sources and we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your own adviser prior to implementation in order to determine whether the strategies mentioned are appropriate for your specific situation.