Ask an Ex-Banker: Home Loans and Home Equity Lines of Credit

Q. Dear Banker, My wife and I are planning an addition to our house. We need the additional space, but I do not want this project to stretch our overall budget. Since I have a specific idea of how much I want to pay, a rise in interest rates would cause us to make different decisions on the project details. Unfortunately, we need to make those decisions now but will not need the money for another 8-12 months. I don’t care if interest rates go down, I like where they are now, but borrowing money before you need it sounds foolish. How does your average Main Streeter hedge against interest rate swings?

Bradley T., San Antonio TX

 A. I understand your question to be whether you should borrow money now, before you need it, because rates are ‘low enough,’ and because you worry rates will not be this low in another 9 months when you actually need the money for the home renovation.

My short answer is: “Maybe, although I personally would not” as to whether you should borrow now and lock in today’s low fixed rates, in anticipation of needing money 9 months from now.  I’ll explain what I mean by that in a moment.  The longer answer, which I’ll detail more fully below that, is that you really need a home equity line of credit, not a fixed-rate home equity loan.

The Short Answer                                      

Should you lock in a loan 9 months early because rates are ‘low enough?’  I’ll make a bunch of assumptions to be able to answer the question specifically, and I hope you can adjust the answer to your own particular situation.

I’ll assume you can get a Prime[1] rate home equity loan for a pretty major $100,000 home renovation at 5%.  That means you’ll pay $5,000 per year in interest, or an extra $3,700 for borrowing 9 months early.

$3,700 is not the end of the world for peace of mind, and so I’ll answer “maybe” borrow this way to lock in an attractive low rate like 5% today.

There are a few reasons, however, why I would not borrow money early myself.  Foremost, we really have no idea which way interest rates will go in the future.

As a former bond guy,[2] I pay quite a bit of attention to interest rates.  Had you asked me at almost any time in the last 10 years whether interest rates were likely to go higher or lower in the next 18 months, I would have said ‘higher’ approximately nine out of ten years, and I would have been wrong approximately nine out of ten years.  That’s not because I’m ill-informed, it’s just because it’s much harder to forecast the future direction of interest rates than it seems.

Because of my own deep uncertainty about the future direction of interest rates, I would argue your choice to borrow 9 months early ‘locks-in’ a loan interest ‘loss’ of $3,700, whereas the rate available to you has a 50-50 chance of being higher or lower 9 months from now.  If you accept my view, then your interest cost for the next 9 months, by not borrowing, is $0, which is much more attractive than losing a guaranteed $3,700.

But what if, 9 months from now, your fixed rate jumps to 7% from today’s 5%, and you’re locking in a 10 year $100,000 loan at $7,000 a year, rather than the more attractive $5,000 a year interest cost?  Well, in that case, if you carry the full sized loan for 10 years, you’ll pay a total of $20,000 more in interest over the life of the loan.  In that stark (probably-worst-case-scenario) example you will have lost out, and you will curse my advice, as well as my children’s children.[3]

Given that the starting position of borrowing early is that you’re $3,700 poorer, however, I see many more scenarios in which you come out ahead by not borrowing early.

If you plan to pay down the loan principal faster than 10 years, for example, or rates shoot up less than 2% over 9 months, or rates stay the same, or rates go down even further, you will have broken even or ended up better off by not borrowing early.  So that’s why I wouldn’t take today’s rates.

The Longer Answer

Instead of a home equity loan locking in today’s good fixed rates, what you actually need is a home equity line of credit (HELOC) from which you can borrow money and pay down at any time.[4],[5]

When I started a business in 2004, I met with an elderly entrepreneur who gave me great advice: Obtain the largest possible home equity line I could, not because I needed it now, but, because as an entrepreneur I needed to be ready to take advantage of opportunities whenever and wherever they might arise.

He was right.  In fact, any person who is both a home owner and a business owner, needs to stop everything right now and start applying for a home equity line of credit.  Why are you still reading this blog post?  Go, do it, now.  I’ll wait.

Ok good, you’re back.  You’re welcome.

In your case, Bradley, the potentially higher rates one year from now will be more than made up by the fact that you can borrow only the amount you need, as you need it, for your home renovation.  The slower drawdown of debt principal and the faster payoff of principal via a home equity line of credit is virtually certain to save you interest costs in the long run.

I believe the fact that HELOC rates are floating – they may go up or they may go down over time – are more than made up for by the variable amount of principal you can take out only as and when you need it.  Over the course of your planned home improvement project, if you borrow for example $33,000 for some period of time, rather than the full $100,000 loan, you’re obviously paying 1/3 of the interest costs than you would on the full amount, during the period of the smaller borrowing.  My point is that even if you end up with the same peak amount of borrowing, $100,000, you’re likely to have paid significantly less in interest in getting to that point.  Most of the time, those savings will outweigh the probability-weighted cost of higher future interest rates.

A special note for small business owners, new and old:  If you’re just starting out, the HELOC may be your only ticket to borrowing money cheaply and flexibly.  Banks only pretend to lend to small businesses, and they certainly do not lend to new small businesses, so it’s hardly worth trying that route.  Banks do lend, however, against houses and home equity, so you’ve got a shot there.

For experienced small business owners: You still need the largest home equity line of credit possible.  You never know when the commercial property right next to your office may become available, and when having $50,000 in ready cash is the difference between acquiring the real estate of your dreams and paying more to lease office space for the next 30 years.  If you have to go to your bank to apply to get the loan to buy the property next door, you’re too late.  You need the home equity line so that you can credibly represent to the sellers your ability to close the transaction within 1 week, in ‘cash.’  That is how the pros do it.[6]

[1][1] Meaning, you have excellent credit, at least above a 720 FICO.  The FICO people sell their scores from all three major credit rating agencies here for about $35.  It’s worth it to pull your score once in a while, so you can confirm you’re eligible for the best rates and there’s no weird activity on your credit reports.  Don’t let FICO trick you into paying $14/month.  That’s stupid.

[2] No, not the Daniel Craig type of Bond guy, much to my wife’s chagrin.

[3] Which is as good a segue as I can think of for repeating Jack Handey’s Deep Thought: “I believe in making the world safe for our children, but not our children’s children, because I don’t think children should be having sex.”

[4] This entire ‘Ask an Ex-Banker’ advice column today assumes you are a responsible borrower, and that debt incurred through a home equity line of credit will go toward productive home and business improvements and not be blown on subsidizing your unsustainable consumer-driven lifestyle.  In your case, Bradley, since you live in San Antonio, that means you can’t blow the whole line of credit on Alamo Lego miniatures and bad Tex-Mex food.   But since readers are, almost by definition, extremely responsible with debt, this hardly bears mentioning.

[5] Most HELOCs give you a drawdown period of, say, 10 years, followed by a payback period of another 10 or 20 years.

[6] While I’m very much in favor of HELOCs for small business owners, I need to acknowledge in the fine print here that things can and have gone wrong for small business owners putting their houses at risk.  Of course this would be terrible.  When you get a HELOC for your small business, make sure you save it for an opportunistic can’t lose situation, not use it to keep your flailing, unsustainable, small business alive.

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3 Replies to “Ask an Ex-Banker: Home Loans and Home Equity Lines of Credit”

  1. That’s exactly how we used our HELOC. We extended it on our investment duplex, and left it there unused while we searched for other investment options. Then about 7 months later, we found one that we wanted – an empty residential lot. We were able to get a better deal with the bank that had foreclosed because we were all cash and could close within a very short time frame.

    But the question for us is – having the HELOC requires us to carry flood insurance on a property we *probably* wouldn’t otherwise carry it on. So that amounts to an inherent fee of $350/year to keep the HELOC open. Once we pay it down and feel we’re done investing, we’ll have to make a choice as to whether to keep it open (and keep buying flood insurance0 or to close it and keep the $350/yr.

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I founded Bankers Anonymous because, as a recovering banker, I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society. For reals. It’s also really fun for me.

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