Meet Jane.

Jane is a thirty-something homeowner with two young kids. She walks into her local bank one day to talk to someone about taking out a loan to replace her outdated furnace. She wanted to put it on her credit card, but she got herself into trouble with credit cards when she was younger, so she wants to look at other options. After talking with her a while, her personal banker, Joe, suggests a home equity line of credit, to which Jane replies, "A what?"

I met many customers like Jane during my time as a personal banker. Many people simply don't know what or how home equity lines of credit work.

A HELOC (home equity line of credit) isn't for everyone, but it often can be the perfect solution for many. First off, you have to be a homeowner and have equity in your home.

What is home equity?

The equity in your home is what you truly own, debt-free. Let's say Jane's house is valued at 200k and she has a mortgage balance of 60k. This would mean that Jane's home equity value is 140k. Over time, the more you pay off any lines against your house (mortgages), the higher your equity value goes. Home improvements that increase the value of your home also raise equity.

A home equity line of credit works much differently than a mortgage or home equity loan. I find it best to view it as working similarly to a credit card. You may draw funds out of the line of credit only as needed. Therefore, technically you can take out a HELOC without ever actually touching the money and having to pay it back.

How much do I qualify for?

Typically, most banks will let you borrow anywhere from 75% to 90% of the equity in your home. To figure this out yourself, take the value of your home, subtract any loans against your home, and multiply that number by the percent the bank will let you borrow. Jane's banker tells her she is able to borrow up to 80% of the equity in her home. You would multiply 140k by .80, coming to a figure of 112k being the maximum amount Jane can borrow. It's important to note that you do not need to borrow the max available. Keep in mind that your debt to income ratio and credit score can also affect how much you qualify for.

How much should I take out a line of credit for?

This is the number one question that was asked to me by customers looking to take out a line of credit. And really, there is no right or wrong answer. You can always take the max available, but you don't have to. There are things you need to consider when deciding how much to borrow. If you are a person who is easily tempted to use that money, even when it's not needed, it probably isn't best to request the max amount unless you know that you will be able to afford the monthly payments.

On the other hand, I also tell people it can be a good idea to take more than you need right now, so you have it as a "cushion." One of my customers came to me to request a HELOC to update her kitchen. Although she qualified for a much higher line, she insisted on only taking what she needed at that time. Not even a year later she came back to me. She had used up the entire amount available on the line of credit and now needed more to fix her roof. She had to go through the entire application process again to do a HELOC increase, and she wasn't happy that it wasn't as simple as saying "I need more money" and having the money readily available. This is the reason I tell people to have a cushion. That cushion can be a lifesaver in emergencies.

What can I use my HELOC to pay?

Most people assume HELOCs can only be used for home renovations, but, in reality, you can use the money for anything. A HELOC can be a great tool to consolidate credit card debt. According to the federal reserve, the average credit card rate was around 15% in 2019, and that rate is often higher for people without excellent credit standings. In contrast, the average HELOC interest rate, according to Bankrate, is around 6%.

What's the application and fee process?

Before heading to the bank, make sure you have the following documents:

  • W2s / 1099 forms
  • Last 2 years federal tax returns
  • Recent pay stubs
  • Proof of any other income

The application process usually takes anywhere from a few days to sometimes weeks, depending on how much information the underwriters may need. The bank typically does an appraisal of the house. In some instances, they may need access to the inside for appraisal, although this is typically not necessary.

After the HELOC is approved, the bank will schedule a closing date and time for you to come in and sign the mountain of paperwork. It can seem like a lot, but you will receive copies of everything, and you have three business days to look it over and cancel if you want.

Common fees associated with HELOCs are lender fees, annual fees, and cancelation fees. Do yourself a favor and research lender options before applying, as there are plenty of banks that do not charge most of these fees. When I worked at M&T Bank, the only fee applicable to a HELOC was a cancelation fee, and that only applied if the line was closed entirely within the first three months.

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The Federal Reserve sets the guardrails for the federal funds rate, and through that helps control the money supply for the nation.

When you take out a loan for a car, charge something to your credit card, or get a personal line of credit, there is going to be an interest rate that applies to your loan.

A lot of different factors go into what you will be charged, including your own personal credit score. But even those with flawless credit still see a minimum charge that they can't get around. That all goes back to the Federal Funds Rate.

One thing consumers rarely realize is that all of our banks are lending money to each other every night. Banks are legally required to maintain a certain percentage of their deposits in non-interest-bearing accounts at the Federal Reserve to ensure they have enough money to cover any withdrawals that may unexpectedly come up. However, deposits can fluctuate and it's very common for some banks to exceed the requirement on certain days while some fall short. In cases like this, banks actually lend each other money to ensure they meet the minimum balance. It's a bit hard to imagine these multibillion-dollar financial institutions needing to borrow money to tide them over for a bit, but it happens every single night at the Federal Reserve. It's also a nice deal for those with balances above the reserve balance requirement to earn a bit of money with cash that would normally just be sitting there.

The Federal Reserve The Federal Reserve


The exact interest rate the banks will charge each other is a matter of negotiation between them, but the Federal Open Market Committee (FOMC) (the arm of the Federal Reserve that sets monetary policy) meets eight times a year to set a target rate. They evaluate a multitude of economic indicators including unemployment, inflation, and consumer confidence to decide the best rate to keep the country in business. The weighted average of all interest rates across these interbank loans is the effective federal funds rate.

This rate has a huge impact on the economy overall as well as your personal finances. The federal funds rate is essentially the cheapest money available to a bank and that feeds into all of the other loans they make. Banks will add a slight upcharge to the rate set by the Fed to determine what is the lowest interest that they will announce for their most creditworthy customers, also known as the prime rate. If you have a variable interest rate loan (very common with credit cards and some student loans), it's likely that the interest rate you pay is a set percentage on top of that prime rate that your lender is paying. That's why in times of low interest rates (it was set at 0% during the Great Recession), a lot of borrowers should go for fixed interest rate loans that won't increase. However, if the federal funds rate was relatively high (it went up to 20% in the early 1980's), a variable interest rate loan may be a better decision as you would be charged less interest should the rate drop without the need to refinance.

The federal funds rate also has a major impact on your investment portfolio. The stock market reacts very strongly to any changes in interest rates from the Federal Reserve, as a lower rate makes it cheaper for companies to borrow and reinvest while a higher rate may restrict capital and slow short-term growth. If you have a significant portion of your investments in equities, a small change in the federal funds rate can have a large impact on your net worth.

Getty Images/Maria Stavreva

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