Many homeowners prefer the flexibility of a Home Equity Line of Credit (HELOC) over a closed term mortgage. While there are merits to a HELOC it isn’t always the best option. HELOC’s tend to be more expensive than their closed variable rate mortgage (VRM) counterpart. The great thing about mortgages is that it’s all about the math. If you know your needs then you can calculate the numbers to determine the best option.
Rainy Day Fund
If you don’t need the money now and want a HELOC “just in case”, then the HELOC is the hands down winner. The other option is to borrow the money using a closed term mortgage and put it in the bank. This makes no sense. Why pay mortgage interest if you don’t even need the money.
Long Term Debt
On the other hand if you need the money now for a long term investment, then the Variable Rate Mortgage is the way to go. A VRM typically has an interest rate 0.50% cheaper than a HELOC. If you are going to borrow $200,000 for at least 5 years than you’ll save $5,000 over the next 5 years by going with the VRM. Easy math.
Short Term Debt
The math gets a little trickier if you need the money now, but think that you’ll be able to pay it off in the next 2-3 years. Although you’ll pay less interest with the VRM, you will have to pay the 3 months interest penalty if it’s paid out prior to the 5 year maturity. The math question is to pit the higher interest costs of the HELOC vs. the penalty on the VRM. With rates on VRM’s as low as 3.0% the penalties are relatively small. Using our $200,000 example, the penalty would only be $1,500. So how long would you have to hold the HELOC before paying more than $1,500 in additional interest? Well, the 0.50% premium on $200,000 works out to $1,000 per year so after 1 ½ years you’ll have paid and extra $1,500 in interest for the flexibility of the HELOC. The bottom line is, if you are going to need your mortgaged funds for more than 1 ½ years then go with the closed term VRM.