Paying down HELOC may trigger freeze

Dear Dr. Don,
I have a $170,000 home equity line of credit with Bank of America that is currently completely drawn. I have $100,000 in my bank account and would like to pay down my HELOC with these funds.

I am, however, concerned that since my home has lost value over the past two years that the lender may freeze the available funds on the line of credit and/or reduce my HELOC. Is this a real concern or am I just being paranoid?
-- Brad Borrows

Dear Brad,
You're not being paranoid. HELOC lenders need to manage their risk exposure in markets where property values are declining. One of the easiest ways for the lender to do so is by freezing or reducing open lines of credit. The FDIC provided some guidance to lenders in a "financial institution letter" dated June 26, 2008. Highlights from that letter are presented below:

• In response to falling home prices and borrower financial difficulties, some financial institutions have reduced or suspended home equity lines of credit (HELOCs) and other institutions may be considering doing this.
• Such actions may be prudent and appropriate ways for institutions to manage credit risk, as articulated more fully in existing supervisory guidance. However, certain legal requirements designed to protect consumers must be followed.
• Regulation Z, implementing the Truth in Lending Act, permits lenders to reduce the credit limit or suspend further extensions of credit if the value of the dwelling securing the loan declines significantly, or if a consumer is likely to be unable to meet his or her obligations as a result of a material change in his or her financial circumstances.
• Compliance with Regulation B and the Fair Housing Act requires lenders to calculate revised property values and determine borrower financial circumstances using consistently applied fact based methods, and implement any resulting limitations without regard to prohibited factors.
• The FDIC urges institutions to work with existing borrowers, when possible, to mitigate financial hardships arising from HELOC reductions or suspensions.

If the financial flexibility of having $100,000 in the bank is worth paying the interest expense on $100,000 of the HELOC balance (less what you're earning on savings), I wouldn't rush to pay down the HELOC. Doing so opens you up to the risk that the line of credit will be reduced or frozen.

You should compare the after-tax cost of debt to the after-tax earnings on the savings to measure this net interest expense. But keep in mind that it's possible that not all of the interest expense on your HELOC is tax deductible.

A review of your liquidity needs and your net interest expense could point you toward paying down the HELOC but not using all of your savings to do so.

Keeping some financial flexibility in the current market environment is worth something. You have to decide what it is worth to you. If you wouldn't qualify for the $175,000 HELOC today based on current home values, you should assume that the line is at risk of being frozen or suspended if you pay it down.