Should You Tap Your Savings to Pay Off Your HELOC?
by , CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
February 3, 2010
We have a credit line second mortgage on our house. I would like to pay this down with savings because the interest rate for the mortgage is much higher than the savings interest rate. My husband wants to maintain the savings for emergencies. Is it better to reduce the long-term debt of the mortgage?
The question of whether or not to pay off a mortgage comes up often. Usually it's not only a matter of the interest you're paying, but also how a mortgage fits into your overall financial picture. For instance, you need to factor in things like tax deductibility and other ways you could put that money to use.
You say you have a "credit line second mortgage" so I'm going to assume that this is a home equity line of credit (HELOC), which allows you to borrow the money when you need it rather than taking a lump sum. In this case, and because you're contemplating paying it off with your emergency fund, there are a few other things to consider.
Calculate the Real Cost of Your Loan
The first thing to do is determine what you're really paying for your loan. You don't mention your current interest rate so, for the sake of example, let's say it's 5 percent. IRS rules say you can deduct the interest expense on up to $100,000 ($50,000 for married filing separately) of home equity debt secured by your home, whether in the form of a regular loan or revolving line of credit. To determine the real cost of your loan you have to factor in the tax deductibility. Let’s assume you’re in the 35 percent tax bracket and the interest on your credit line is fully deductible. In this instance, you'd really be paying about 3.25 percent.
Compare This with What You’re Earning
In today's interest rate environment, chances are the after-tax rate on your HELOC is still higher than what you're earning on your savings. Plus, most HELOCs have adjustable rates, often tied to the prime rate, so the cost will likely go up at some point (and perhaps outpace increases in the interest rate on your savings). These are two good reasons to use your savings to pay off your home equity loan.
Look at the Bigger Picture
That said, there are a couple of other things to think about. I'm a big proponent of having an emergency fund to cover 3–6 months of expenses, but a HELOC can be a type of emergency fund—as long as you're not tempted to use it to support a lifestyle that you can’t really afford. That's the crux of the matter.
To make sure you're covered—and don't overextend—consider these variables:
- Overall debt—Paying off a HELOC is a good idea. But if you have high interest credit card balances or other non-deductible debt, you should focus on those first. This is really important.
- Fixed expenses—If your monthly expenses are predictable and relatively low, you’re in a better position to pay off your credit line and still feel confident that you can handle everyday needs.
- The term of your loan—A HELOC is usually for a fixed period determined by the lender. Check the current term of your loan. If you're close to the end, you may have no choice but to pay it off or renegotiate to extend the life of the loan. In any case, if you choose to rely on a HELOC for future emergencies, make sure the term is long enough to give you the safety net you need.
Your ultimate goal should be to keep a lid on all types of debt—credit cards, car loans, you name it—as well as home equity debt. But if you think you're going to need the money soon, paying off your HELOC with your savings just to turn around and borrow again wouldn't make much sense.
A Win/Win Alternative
If you and your husband still don’t agree, there’s nothing wrong with paying off just a part of your line of credit now, and then paying off the rest over time. You can also take a look at your budget and see if you can increase the monthly payment on your remaining balance. This way you'll have the satisfaction of decreasing the amount of interest you're paying—and your husband will feel confident that you still have some savings. And if a costly emergency arises, you can tap into your HELOC when you need it.
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