Home Equity Lines of Credit are back.
Good news or bad news?
A decade ago, banks were giving away home equity lines of credit (HELOCs) the way they used to hand out free toasters. When the mortgage crisis hit, they became as scarce as Chicago Cubs World Series rings.
Now they’re becoming ubiquitous again, although this time with tougher qualification rules. This could be seen as a good thing or a bad thing depending on your perspective.
What’s a HELOC? It’s a second mortgage, but it’s like having a super-high-balance credit card tied to the equity in your home. Like any credit line, you should understand exactly how they work before you get one.
A HELOC is a 25-year REVOLVING debt that lets you extract money and pay it back at your convenience, typically for a period of 15 years, at which point you cannot make any more draws, and you must pay off your balance over the remaining 10 years.
The interest rate (typically Prime plus 1%) is much lower than credit cards, because you’re putting up your home as collateral. Your credit limit is typically 75% to 80% of your home’s value. If your home is worth $500,000, for example, and your first mortgage balance is $300,000, your HELOC limit would be $100,000.
Assuming you need to raise some money for home improvements, or to buy a new car, you may want to compare a HELOC to a traditional cash-out refinance of your first mortgage.
1. Minimal closing costs.
2. Low interest-only payment.
3. You pay interest only on the amount you owe.
4. Keeps your first mortgage intact, assuming it’s at lower-than-market rate.
1. Rate is adjustable, with an upper limit of 18%
2. Credit line can be frozen at bank’s discretion.
3. Early closure penalties are common.
4. Annual fee even with a zero balance.
CASH-OUT FIRST MORTGAGE ADVANTAGES:
1. Fixed rate and payment. No surprises.
2. Get all cash you need in lump sum – no chance of having credit line frozen.
3. May be able to get a lower rate than your current first mortgage, thus “killing two birds with one stone”.
CASH-OUT FIRST MORTGAGE DISADVANTAGES:
1. Higher closing costs
2. Pay interest on full amount drawn from day one.
3. If current rates are higher than existing first mortgage, you convert existing debt to higher rate.
There are other reasons to consider a HELOC, even if you don’t need the money immediately. For example, many homeowners would like to have a ready source of cash for unforeseen emergencies.
So why could this be a bad thing? Many are worried that easy access to credit lines will lure people into the habit of using their home’s equity to finance a lifestyle beyond what their earnings allow. Indeed, it was home equity, not wage growth, which was largely responsible for fueling last decade’s robust economy.
During the mid-2000s, HELOCS were given away with very few questions asked, and lenders allowed borrowers to extract more than 100% of their equity. HELOCS were tapped to pay for expensive vacations, new cars, and other luxury items. And many people used them to finance the down payment of additional properties. When the bubble burst and trillions of dollars of equity vanished, millions of US homeowners found themselves “under water”. We’re still digging out from the mess today, although property values in many areas of the country have fully recovered.
But today, unlike in 2003-2007, all borrowers must qualify based on their ability to repay. No more “easy qualifying”. We’re hoping lenders AND HOMEOWNERS don’t repeat the mistakes they made during the last decade.
Finet of Saratoga does not currently offer stand-alone HELOCs (we offer them only when placed in conjunction with a new first mortgage), but we are happy to provide analysis, advice and referrals. Call us at (408)872-8100 for straight answers.