Bury the HELOC or save for a down payment?

[Urchina]

What would you do?

We have a 2 bdr condo, purchased 6.5 years ago. In May of 2008 we refinanced the condo from an ARM to a 30-year fixed-rate mortgage and a HELOC. We've always thought that we would try to keep this place as a rental, and once the HELOC is paid off rent will cover all expenses on the condo and give us a small positive cash flow.

We are now in the early stages of looking for a larger house, since we're beginning to outgrow the condo. Despite declining housing prices, we're still in a very high-cost area. If we sold the condo, we would probably have a 20 to 25% down payment on a modest 3 bedroom, But, we'd really like to figure out if we can keep the condo.

If we saved up a big enough chunk (possible in the next couple of years) and refinanced the condo, we might be able to buy a bigger place and keep the condo. However, the monkey wrench here is that the HELOC, with 65K on it, is an adjustable with a ceiling of 18%. I'm thinking that in the next couple of years we might see some real inflation, and this HELOC payment could balloon quickly. We can afford the payments if it does balloon, but it would make it difficult to keep the condo and buy a bigger place

So here's the question: Do we put excess cash towards paying down the HELOC, or do we continue on with our regular HELOC payments (which pay down the principal a little, but not much) and save cash towards a down payment? The benefit of the cash is that we could, later, use it to pay off the HELOC in a lump sum if that made sense. If we put the savings into paying off the HELOC, we lose that flexibility. Is the flexibility really worth anything at all, though?

The theoretical opportunity costs and benefits of each option are a bit murky to me, and my limited Excel skills are not helping me model it well. I'm mostly looking for ideas, angles to consider, things we may not have thought of.

To many of you this may seem a pathetically naive question, but it's not a scenario I've been through before and I'm having a hard time getting my mind wrapped around it, for whatever reason.

TIA!

 

[brewer12345]

I was in a similar situation several years ago where I thought about keeping the condo, but eventually decided that I did not need a second job (landlording) on top of my day job and grad school at night. Having said that, I would suggest keeping the financing question (HELOC) separate from the asset question (keeping the condo or not).

On the financing side, if you really do have that much equity in the place, you have a number of options to alleviate the interest rate risk. You could refi the whole package with a single mortgage (either conventional or something like Pen Fed's 20 year 4.99% home equity fixed loan). You could also leave the 30 year fixed in place and refi the HELOC. This could be done with either a fixed, closed end home equity loan or with something like Pen Fed's 5/5 HELOC (something I have seen nowhere else). The 5/5 HELOC is technically adjustable, but is fixed for the first 5 years and then adjusts once for another 5 years, with limits on how much it can adjust, etc. (go look at the fine print).

 

[Nords]

What would you do?
I'm mostly looking for ideas, angles to consider, things we may not have thought of.

How hard do you want to work for your money? And if you buy the home with a larger down payment, then you'll avoid the expense of mortgage insurance while getting much better interest rates. Our last refinance (Jan 09) was a far more tedious & nitpicking affair than the one we went through in 2005.

We've been landlords because it's been easier than whatever other choices we were contemplating at the time-- selling the house into an imploding housing bubble, trying to sell one house while buying another, trying to sell the house into a credit bubble, and so on. Logistics usually triumphed over finances.

These classics will go into far more detail on the financial analysis, management, & lifestyle issues than you perhaps care to delve:
(1) Investing in Real Estate, 4th edition or later, by Andrew McLean & Gary W. Eldred (who's taken over the new editions) and
(2) Landlording by Leigh Robinson (7th edition or later).

Anyone who can't muster the effort to get through both of those books is probably not going to be ready for, nor enjoy, the landlording experience.

 

[clifp]

Here are a few other thoughts to consider.

If interest rates do rise due to inflation, housing prices will almost certainly also be rising. In which case, your rising equity will probably be able to refinance either the condo or the new house with a fixed mortgages/HELCO (although likely a far higher interest rate). Once again we will all be of to the races enjoying a new bubble economy.

It sounds like you are not really using your HELOC as credit line but rather as separate installment loan. In which case you don't really need the flexibility and taking advantage of fixed Home Equity Loan at place like Pen Fed as Brewer suggested probably will save you money.

In addition to the questions Nords asked about do we really want to be landlord. You and DH should spend some time asking yourself how much risk are you truey comfortable taking. It is one thing to borrow 75-80% of the money for your principal residence. It is another thing to borrow 80% on two pieces of property.

You and I along with most of the other great investing minds in the world forsee a future with high inflation, in which your gamble will pay off. On the other hand, I just read that CA lost 1.3 million American in the last decade. It is worth considering what happens if this trend continues,who is going to pay more money for the Condo in future years, or pay increased rent? Leverage is great when assets are increasing in value but it works both ways.

 

[Urchina]

Thanks for the ideas so far.

RE: landlording, we've done quite a bit of reading on it, but I'll check out the two books Nords suggested. As it turns out, I have applicable experience -- one of my summer jobs in college was as a conference hall director. I was often the sole staff person taking care of a dorm which was rented out to community groups in the summer. I was on a pager 24/7 and spent most of my time handling repairs, complaints, move ins/outs, and other sundry details. It's not the same as landlording, but it is related and I felt just fine about it. Still do.

Clifp, you're right, the HELOC is not a line of credit, it's actually a second mortgage. We split our mortgage into two pieces so as to allow us to lower our monthly payment by paying one off more quickly. The refi you and Brewer both mentioned is an opportunity for us to eliminate the interest rate risk, true, but I'm still wondering: should I pay off the HELOC or have the cash on hand for a down payment on a bigger place later on? Or is cash in the house equivalent to cash in hand when it comes time to buy (assuming we'd refinance then and pull money out of the condo)?

 

[FinanceDude]

Clifp, you're right, the HELOC is not a line of credit, it's actually a second mortgage. We split our mortgage into two pieces so as to allow us to lower our monthly payment by paying one off more quickly. The refi you and Brewer both mentioned is an opportunity for us to eliminate the interest rate risk, true, but I'm still wondering: should I pay off the HELOC or have the cash on hand for a down payment on a bigger place later on? Or is cash in the house equivalent to cash in hand when it comes time to buy (assuming we'd refinance then and pull money out of the condo)?

If you mean pay off the second mortgage, then that would be the first thing I would do.........

Home equity is the way most folks "trade up" homes. The days of easy credit are over.........

I have a HELOC. but its our form of security in case of emergency, it is untapped and I pay NO fees to keep it around.........

 

[Lusitan]

What's the current interest rate on the HELOC?

In the past, whenever I've paid off debt, I have typically done it by saving up the cash in a savings account (or CDs) or money market account (i.e., somewhere stable) and then waiting until I've had a large enough stash to either pay off the debt completely or make a big dent in it. I've always preferred that approach to the make-extra-monthly-debt-payments approach, I guess for the flexibility.

In your case, a HELOC with a ceiling of 18% would freak me out (especially the way our govt is printing dollar bills), so I would probably continue to save in a stable cash account but as the final goal I would probably look to either drastically reduce or completely pay off the HELOC before using that cash to do anything else like buy a new place.

 

[bubba]

In your case, a HELOC with a ceiling of 18% would freak me out (especially the way our govt is printing dollar bills), so I would probably continue to save in a stable cash account but as the final goal I would probably look to either drastically reduce or completely pay off the HELOC before using that cash to do anything else like buy a new place.

This pretty much sums up my thoughts. That rate would scare me to death, so I would want to get rid of the HELOC before purchasing another home just in case if/when the rates shoot up. I've always gone the extra payment route with debt, but with the economy making all jobs less secure, I'm saving extra cash now, and will pay off our HELOC if the rate jumps. Otherwise, I have the cash set aside in case of a j*b loss. My thought is I'd make payments from this stash while looking for another j*b.