HELOC (hee-lok) is an acronym for Home Equity Line of Credit, a way of extending credit to a homeowner using equity in their home. Borrowers typically draw funds on the line as they see fit and are only required to pay interest each month at a rate that fluctuates based on the prime rate. Application and approval processes are generally simpler and cheaper than a fixed mortgage and accessing cash can be as easy as writing a check or swiping a debit card tied to the line. Terms are typically 10 years (can range from 5-20) at which point they enter repayment, where access to the line is closed and any balance is due at once or amortized into a fixed payment for a pre-determined number of years.
If headlines about people using their homes as piggy banks ring any bells, these were typically the vehicles used to do so. HELOCs peaked in popularity during the housing bubble with nearly $300 billion in currently outstanding credit stemming from lines opened between 2005 and 2008 according to Experian. These lines are starting to enter the repayment or “reset” phase in large numbers. Many are unaware of their terms and have been making interest only payments on balances due.
The fear is that these borrowers will struggle as their required monthly payments jump substantially when loans amortize or be unable to refinance should a lump sum payment be due.
Much has been written in recent months about the potential for HELOCs to become the next great personal finance crisis in this country. I’d like to talk about how much of a threat really exists and what to do about your own line of credit should you have one.
HELOCS are not just about greedy cash grabs during the housing boom. There are perfectly good reasons why one might open a HELOC. With interest rates at historic lows for close to a decade, it’s not uncommon for clients or others we consult with to open lines. It offers repayment flexibility, provides attractive tax benefits for some and can be useful tools when making home improvements, solving temporary cash flow issues or as another emergency backstop for cash while not disturbing long term investments.
Regardless of the initial intent of your line of credit, if the term is almost up or you’re unsure when it expires, now’s the time to do some research and make some decisions. The best way to move forward can vary widely based on your individual circumstance.
For instance, even if you have an open line with nothing owed, it’s worth considering changes to the interest rate or other terms if your line of credit renews or resets. If renewing, pay close attention to any new terms to make sure they still fit with your reasoning for having the line in the first place. If not renewing, consider the impact closing the line might have on your overall available credit and credit score.
If you’ve been paying off the principal balance over time, but still have a balance, find out how much longer you have before it converts to a fixed payment. Can you accelerate or increase your payments now to avoid having to move to permanent financing or facing a balloon payment you might not be able to make?
If you have a high principal balance and have been making interest only payments for a long period of time, it’s really time to make sure you have a plan in place. With a rebound in housing values since the market downturn and mortgage rates still very low, it might be time to refinance into a fixed rate mortgage. If that’s not likely due to credit, home value or other issues, then proactively talk to your lender about what options may be available to you to negotiate more favorable terms before it’s too late.
Forecasting precisely how this or any other phenomenon will impact markets is not something we believe we or anyone else can do with precision. That said, comparisons of the coming wave of resetting HELOCs to the housing bubble of the last decade seem overdone at best.
First, we have to consider the potential size of the problem. When mortgages were going bad last decade, we were dealing with loans on 80%, 90% even 100% of a home’s original appraisal in a $9.9 trillion mortgage market with rapidly declining home values.
By comparison, these lines typically cover 5-15% of a home’s value and the $250-300 billion in outstanding credit seems almost immaterial. The housing market has improved dramatically as have repayment rates on first mortgages. Even if all HELOCs were to go bad, an event that is virtually impossible, the impact would be exponentially smaller.
In terms of borrowers’ ability to pay, we have much healthier employment rates today than during the market downturn and wages are rising, albeit very slowly, creating a healthier environment for borrowers than existed in 2008 & 2009. It is also believed that more than half of these credit lines held by owners who are or were underwater on their mortgages and credit lines have already reset.
While most fears seem overblown, there are some risks. If required payments start to rise sharply at the same time the Fed starts to raise rates, it could compound the inability of some borrowers to stay current. This would likely spread to other forms of debt as well, as the borrowers most impacted might be unable to keep up with other obligations.
This debt also falls directly on bank balance sheets, from large institutions to small community banks and credit unions, as opposed to having been sold off to Fannie Mae or Freddie Mac. This direct stress to lenders could create a lull or dip in a recovering financial sector.
In short, the potential impact of a HELOC reset bubble to the overall economy is unlikely to be any greater than any of the other threats markets routinely face.
If you do have a home equity line of credit, now’s the time to educate yourself on the terms and talk with your financial planner to determine the best path forward regardless of how much you owe. If it’s certain to cause a burden in the near future, reach out to your lender and start the conversation before it’s too late.