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   ARTICLE   |   From Scotsman Guide Residential Edition   |   October 2007

Harness the HELOC

Learn the power of equity lines to help clients gain financial flexibility

From our first piggy bank to our initial interest-bearing savings account to our own checking account, most of us learned early on that the more money we save, the better.

The problem with this philosophy is that many banks pay little interest. In fact, many checking accounts pay zero interest and charge a wide variety of fees. In the meantime, these same banks use our money to make money for themselves.

For many borrowers, this money is stagnant. To make it active, borrowers need a different financial vehicle.

Mortgage brokers looking to help clients lessen the impact their loans should master the math of home equity lines of credit (HELOC). By using banking rules to their advantage, borrowers can save money and deliver more business to your doorstep.

Some people interpret HELOCs as high-interest-rate, debt-building products. But equity lines also represent a chance for borrowers’ financial independence. Brokers can teach their clients this, but only if they understand the differences between closed-end and open-end loans, the uses for interest cancellation and how to take advantage of the system.

Closed-end vs. open-end loans

Closed- and open-end loans feature different rules. Closed-end loans (e.g., mortgage loans and most installment loans) are like a one-way street. The lender only will apply payments once a month and only if the minimum payment is made.

These loans also don’t allow borrowers to access their equity. For example, if your borrowers originally borrowed $200,000 on their home loan, paid their mortgage on time for more than 10 years and needed to borrow back $50,000, their closed-end mortgage wouldn’t allow it.

Further, the interest on a closed-end amortized loan is front-loaded in the lender’s favor. If your borrowers originally borrowed $200,000 at 6-percent interest on a 30-year fixed-rate loan, they’d end up paying $231,676 in interest charges on top of the $200,000 they originally borrowed.

Open-end loans, on the other hand, have different rules that can lead to different financial results. These loan types can be thought of as a two-way street. Payments can be made multiple times a month, and lenders must apply these payments as they’re received.

Borrowers also can draw money out of an open-end loan multiple times a month, making this loan type a more liquid account.

Open-end loans also calculate interest differently than closed-end loans. Rather than multiply the interest rate by the month-end balance, open-end loans multiply the interest rate by the average daily balance.

Interest cancellation

Using the rules of an open-end loan, such as a typical HELOC, borrowers can create an interest-cancellation account. The concept is fairly simple: They borrow the bank’s money for a period of time and pay little interest, regardless of interest rate.

Let’s imagine that it’s the first of the month and for whatever reason, your borrowers’ business was slow for the past month. Your borrowers’ bills are due, and their next paycheck won’t arrive for two weeks.

They buy $100 worth of groceries using a debit card from a HELOC with an interest rate of 10 percent. They also treat their family to dinner, accessing another $200. A week down the road, they take out another $700 from their HELOC to pay for their daughter’s braces. A few days later, they use that same HELOC to make a mortgage payment of $1,199.

Through the first half of the month, they owe $2,199 on their equity line. After receiving a $3,000 paycheck on the 15th of the month, they immediately pay off their equity line and carry a zero balance for the rest of the month.

Their approximate average daily balance would be $1,000. As such, their interest charge would be $8.33 ($1,000 multiplied by 10 percent, divided by 12 months).

By paying off the balance midway through the month, the borrowers effectively “canceled” the interest they would have been charged for the month. Even at a 10-percent-interest rate, they paid only $8.33 while borrowing $2,199.

HELOCs as checking accounts

In this way, HELOCs can be powerful financial tools. The key is convertingequity lines into primary checking accounts.

Borrowing from a HELOC to make advance principal contributions on a mortgage can save your borrowers money. For example, a $5,000 principal contribution made at the beginning of a 30-year fixed-rate $200,000 mortgage would save 23 payments, or $27,579, including $23,437 in interest.

What would happen if they borrowed that $5,000 from their 10-percent HELOC? Let’s work with a net monthly income of $5,000 paid at the first of every month. Let’s also imagine your borrowers have total monthly expenses of $4,000, leaving a monthly discretionary income of $1,000.

If they use that $1,000 each month to pay back their HELOC, they will nearly pay off their $5,000 in borrowings in five months, during which time their interest payments will total less than $86.

By continuing to borrow from their HELOC — and using that money to pay down their mortgage principal — borrowers can further reduce their mortgage-payoff time. In essence, they’ll be on fast track for financial freedom without reducing their monthly budget.

It’s important to note that some lenders will provide HELOCs for borrowers with little to no equity in their homes by doing a partial pay-down on the first mortgage. For example, a $200,000 first mortgage can become a $180,000 first mortgage with a $20,000 HELOC. Borrowers can then begin to pay off the HELOC before using it all over again.

A few cautions

Using a HELOC as a primary checking account — and borrowing sums at certain times to pay down a mortgage — won’t work if borrowers consistently spend more money than they make. In fact, it’s crucial that they have discretionary income to help pay down their equity line.

In addition, deciding how much money to borrow — and when to borrow it — can be a challenge. Borrowing too much against a HELOC may lead to increased interest charges. Borrowing too little may not yield the greatest savings. The trick is effectively coordinating your borrowers’ income, expenses, mortgage and equity line.

Finally, note that the interest rates on HELOCs typically are based on the prime interest rate plus or minus a margin. These interest rates can adjust up or down whenever the prime rate adjusts. With proper planning and payoff, these lines of credit can be used to borrowers’ advantage no matter the rate. The key is properly timing withdrawals and maintaining strict adherence to self-imposed payment schedules.

•  •  •

Effectively communicating this paradigm shift requires a variety of methods. Some borrowers are big-picture thinkers, while others are detail-oriented. Brokers can begin by reviewing HELOC information and developing their own presentations with general concepts, side-by-side comparisons and more. Prepare spreadsheets that lay out specific calculations and monetary minutiae, as well.

As mortgage professionals, we should help our clients as much as possible. Harnessing their HELOCs can be the answer for some. Teach them to do this and they’ll send business your way for years to come.



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