The Chicago Sun-Times has an article today (5/29/06) that suggests it’s time for HELOC borrowers to pay down their debt and find other means to finance big projects.

Here’s a basic rule of thumb: When the HELOC rate gets to 7 percent or more, pay off the line. That’s comparable to getting a guaranteed 7-percent-plus rate of return on your investments. (Do note that paying off your HELOC debt doesn’t close the line. It will still be available in case of emergencies.)…

With the prime rate at 8 percent, it’s time to consider financing any big projects with your savings and investments if you have them, deferring your expenditures until you have had a chance to save up the money or until rates are once again at low levels.

There’s no question that rising rates make HELOC financing much less attractive than in the recent past. However, I don’t necessarily agree that the 7% rate threshhold is a sound rule of thumb for giving up on HELOC financing. Here’s why:

• Tax Deduction - if you itemize tax deductions (most homeowners do) you’re aware that interest paid on a HELOC is generally deductible. This subtantially lowers the effective interest cost to you. As this table shows that a 7% HELOC for someone in the 25% tax-bracket still has an effective interest rate of only 5.25%.

• Real Rates - HELOC rates have gone up primarily because of Federal Reserve moves to fend off rising inflation:
   

  Year	Avg Chg in CPI
  2002	1.6%
  2003	2.3%
  2004	2.7%
  2005	3.4%

  But rising inflation also means the “real” (inlation-adjusted) cost of the interest paid on a HELOC needs to be refigured. If your HELOC rate in 2003 was 4.5% and inflation averaged 2.3%, the real cost was 2.2%. In 2005, the same HELOC may have had an after-inflation cost of 3.6% (7% less 3.4% inlation); not nearly as good as 2.2%, but still a relatively inexpensive way to borrow.

• Alternatives - Finally, what are the alternatives? Credit card debt can make sense if you are very cautious and can effectively play the 0% balance transfer game. But this is risky and not a good idea for most.

  Fixed rate home equity loans and cash-out refinancings sound good, but you’ll likely incur substantial closing costs and will lose the monthly payment flexibility afforded by a HELOC.

In sum, the golden days of low-rate HELOC financing are certainly gone, but when you look at the complete picture, HELOC’s still can make good financial sense - even 7%+ HELOCs.

Technorati Tags: finance big projects, HELOC rate, HELOC debt, HELOC