SubscribeThu 22 Mar 2007
Dear Dong,
Is there any financial reason (I know there are psychological ones) to have
money in a savings account when you are paying a significantly higher rate on
your HELOC? For example, if the savings account is paying 5% and the HELOC is
costing you Prime (now 8.25%), wouldn’t it make sense to pay down as much of
the HELOC as possible and then borrow from it (with no transaction costs) when
you needed to dip into your “savings?”
Sincerely,
CFO
Simple Answer: No.
There’s absolutely no reason not to pay down a HELOC from savings if you have it. As you said, you can always dip into the HELOC if the need arises. However that is not to say that you shouldn’t have extra savings once you’ve paid off the HELOC. While I think it’s okay to “fund” some of you emergency fund via a HELOC, it’s better to fund it with actual savings.
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March 25th, 2007 at 2:35 pm
Not so fast there, Dong. What if your savings is in a vehicle with little or no tax exposure like a muni bond money market account or something that throws off qualified dividends (taxable at 15%). And you’re in a 33 or 35% federal tax bracket and a 9.3% state tax bracket (like CA). Since the deductible interest on the HELOC brings it’s net cost waaay down, do you still want to stick with your answer?
March 26th, 2007 at 6:55 am
thc,
You bring up a good point which I should’ve been more careful to answer. It’s important to consider after tax rates on both the loan, and the return on savings. In the the CFO’s case since his saving was in a taxable account (or assumed to be in), the tax savings on the HELOC would’ve been a wash. Let’s say for instance CFO were in california and at the 35% tax bracket giving him a marginal tax rate of 44.3%. On after tax basis his required rate of return on savings account would be:
(1/(1-.443))*r = 8.25%
r = 4.6%
This is effective tax adjusted cost of borrowing. On his savings side, his after tax rate of return is simply r’*(1-.443).
In his current case with the 5% saving acount it works out to 2.785%. Hence not a good tradeoff. It would be difficult to find a rate of return in a taxable saving/money market fund account that makes a good tradeoff as it would basically require a rate of return equal to his HELOC rate which would an amazing rate for a savings account.
However, as you rightly point out he might be able to find a municipal fund that gave him a rate of return that surpassed what he was paying. Assuming a fund that could avoid both federal and state taxes that fund would only need require a rate of 4.6% - certainly quite doable.
The calculation for something throwing off qualified dividends is bit trickier, and at this point I’m going to take a pass on as I’m personally not sure what type of investment throws off qualified dividends but shares a similar risk profile to a savings account.
March 26th, 2007 at 8:28 am
Nice explanation.
My whole point is that there are no “simple answers” to financial planning questions. A question like CFO’s cannot be answered accurately without knowing the taxable nature of his/her savings and its earnings rate, his/her tax bracket, whether he/she itemizes, is he/she subject to AMT, etc. To throw out a “simple answer” is not being very responsible.