We seem to have washed away the bad taste of the housing-market crash — at least enough to return to using home-equity credit.
But experts say there are some new rules to the game this time around.
Home-equity lines of credit, or HELOCs, allow homeowners to tap their home’s equity through a loan based on the home’s value, minus the primary mortgage debt. A homeowner can also use a home-equity line of credit that works like a credit card.
HELOCs were a popular option for lenders and homeowners during the 2000 housing boom, and played a part in the subsequent recession. Experts say the stability of the economy now has lenders and homeowners feeling comfortable enough to return to HELOCs, whether it’s for cash flow or for home improvement.
The terms “home-equity loan” and “home-equity line of credit” have distinct meanings. While both are loans in which you borrow against the equity you have in your home, a home-equity loan is a one-time loan for a set amount often at a set interest rate.
A home-equity line of credit works more like a credit card. The homeowner pays a fee and can borrow up to a certain amount within a specific period of time. The loan is also paid off like a mortgage, but the homeowner can borrow again as long as the amount is less than the cap and it is within the time period.
In most cases, the interest payments on a home-equity loan are tax deductible as well as on the line of credit.
According to a new market analysis by Inside Mortgage Finance, mortgage lenders originated an estimated $17 billion in new home-equity loans during the second quarter of 2014, an almost 31 percent increase from the previous period.
“We’re nowhere near where we were in mid-2000s, but to a greater extent they are becoming more available,” said Andrew Leventis, an economist with the Federal Housing Finance Agency.
Kelly Kockos, senior vice president of home equity at Wells Fargo, has seen the same trend.
“They’re not dramatically up, but there’s a renewed interest,” she said. “It’s a great way for borrowers to use money responsibly.”
Lesson time
Unless it isn’t, added Leventis, who recently completed a study about the relationship between second liens, first-mortgage outcomes and borrower credit.
“It gives homeowners some opportunity to cash out equity, but there are also the possibilities for some bad decisions,” he said. “It’s really hard to know what people are using them for.”
Some of the bad decisions of the pre-recessiont era were actually encouraged by lenders, he said.
“Prior to the craziness of the housing boom, there were some significant restraints to getting a HELOC, and those were loosened during the housing boom,” Leventis said. “HELOCs … often introduced new burdens that proved to be problematic and were a factor that contributed to some mortgage defaults.”
David Gross, a senior instructor of finance at the University of Colorado Leeds School of Business, said there the real estate crash offered lessons for both consumers and lenders.
Lenders sometimes provided HELOCs to people who never should have had them.
“Part of it had to do with the change in structure of the loans,” said Gross. “They were granted to individuals in financial situations that were never granted prior to the housing boom.” Lenders changed their requirements and actually sought borrowers.
But there has been a shift of attitude about HELOCs since the housing boom, Kockos said.
“We’re in a very different economy and environment than 2005,” she said. “Customers still want access to home equity, but now it’s for what they need, versus what they want.”
Homeowners who might have used their home’s equity for vacations or luxury purchases such as giant TVs or boats are now outnumbered by those who use them for home improvement, debt consolidation or to buy a new home, she said.
Rethinking equity
Another lesson that was learned, Gross said, was how consumers viewed home equity.
“There was an interesting phenomenon that took place,” he said. Consumers felt comfortable cashing out some of the equity in their home, whereas before the boom, they’d have used it to fund retirement, or planned to have the home paid off before retirement.
People make dramatically different consumption decisions based on the nature of their assets and not their preferences, Gross said.
“I’m not trying to judge preferences,” he added. But, for example, “given an alternative savings option, they wouldn’t have cashed out part of their 401(K) because their stocks went up.”
To avoid history repeating itself, Wells Fargo now offers an 30-year amortized home-equity line of credit product, Kockos said, which means customers have a fixed monthly payment that includes interest and principle.
“Wells Fargo no longer offers an interest-only home-equity line of credit product except for customers who have more than $1million in reserves in the bank,” she said. “An amortized payment helps customers manage the debt better and helps to avoid payment shock at the end of the draw period.”
Additionally, the industry as a whole has changed its home-equity loan process, she said.
“In the current mortgage environment, the process of getting a home-equity loan is similar to getting a mortgage,” Kockos said. “It’s not as easy to tap in to your home equity as it was in 2005.”
So: Should you get one?
When considering a HELOC, Wells Fargo recommends taking a quick look at how much you pay on debts, such as such as mortgage, credit card, and student-loan payments, and making sure the total isn’t more than 43 percent of your monthly pretax income.
When it comes to how much you can afford to borrow, they recommend adding the amount you want to borrow to the amount you already owe on your home and making sure the total isn’t more than 85 percent of your home’s value.
For example, if a home is worth $200,000 and the mortgage balance is $120,000, that means there’s $80,000 in total equity. The homeowner might be able to borrow up to $40,000 of that equity before reaching 80 percent of the home’s value.
If people use HELOCs responsibly, everyone stands to win, she added. Housing prices could increase because of home improvements; consumers repay their loans, which signal job stability; and instead of keeping all their money in savings, consumers spend it in the U.S. economy.
“That’s great for everybody,” she said. “From an economic standpoint, that’s good.” But get a HELOCs with a healthy dose of caution, Gross added.
“There are people who are not using HELOCs for the intended purpose, to improve your home,” he said. “They are consuming retirement savings early, and that has to be understood when the trigger is pulled.”
Questions to ask about a home-equity line of credit
• Can I afford it? Consider not just the monthly payments. HELOCs may come with upfront fees like a traditional mortgage. Many HELOCs also have adjustable rates. If rates rise, your payments will go up.
• Why am I taking this loan? Is it for home improvements? Paying for college? These are generally good investments that may be worth taking equity out of your home. But if you are taking a home equity loan to finance a lifestyle beyond your means, it can become a vicious circle of debt that ends badly.
• Am I getting the best deal? Borrowers need to shop around. Different lenders will offer different loan terms. Fees, interest rates and repayment plans will vary, so don’t just go to one lender.
• Did I read the fine print? HELOCs can have a lot of variables. Is there a prepayment penalty if you want to pay it off early? Don’t ask just what the interest rate is. Ask: Is it variable? If so, what benchmark rate is it tied to? How much can the benchmark change?
— Mortgage Bankers Association
