Americans have more home equity than ever before. This is how a HELOC works

Rising home prices in the United States have pushed homeowners’ equity to record levels. This means that you can convert the increased value of your home into cash. It seems obvious, right?

Well, there is more to the story. Many homeowners are reluctant to use home equity loans to operate their home as an ATM. And while there are valid reasons to be cautious, there are some benefits that homeowners who are short on cash may miss out on.

As stocks rise, HELOCs lose popularity

Americans’ exploitable equity – the amount they can cash out from rising home values ​​- jumped $ 380 billion (7%) in the first quarter to $ 5.8 trillion , according to the latest Mortgage Monitor report from Black Knight, a real estate agency and mortgage data analysis company. This is the strongest growth in a single quarter since 2005.

Over the past 12 months, the average homeowner with a mortgage has earned $ 14,700 in usable equity and has $ 113,900 in total.

Black Knight

Faced with this meteoric rise in values, the share of total equity that Americans took out of their homes hit a four-year low in the first quarter of 2018. Mortgage owners withdrew $ 63 billion in equity using a refinance with cash or a home equity line of credit. , Where HELOC, in the first trimester. That’s a 7% drop from the fourth quarter and up 1.1% from a year ago, Black Knight found.

Additionally: While rising rates on senior mortgages typically boost HELOC loans because people don’t want to refinance with lower rate loans, the volume of equity taken out with a HELOC has fallen to its lowest level. lowest level in two years, according to the report.

Homeowners still view their home, which is often their most important investment, as a source of money. Withdrawal refinances increased from 5% to 70% of total refinancing transactions over the past year. Black Knight found that nearly half of homeowners who opted for cash refinancing increased their interest rates in the process.

The preference for cash-out refinancing over HELOC seems counter-intuitive to a short-term cash flow requirement. Homeowners who need cash fast could benefit from a HELOC if they use it the right way – and understand what they’re getting into, experts say.

Hike in rates and lingering fears choke HELOC’s growth

HELOCs have lost popularity in recent years. For starters, a rise in short-term interest rates is off-putting to potential borrowers because HELOCs come with variable interest rates. Mortgage rates have largely been on the rise, making borrowing more expensive.

Another blow to HELOCs: the new tax law that removes the mortgage interest deduction for loans that are not used for home improvement projects. If you plan to use a HELOC for other purposes, losing that tax advantage makes HELOCs less attractive, especially compared to other alternatives, says Greg McBride, CFA, chief financial analyst at .

“For consumers with strong credit profiles, there are single-digit interest rates on unsecured personal loans,” McBride points out. With a personal loan, “a borrower can have cash on hand within 72 hours, which is a convenient alternative to comparable interest charges.”

The scars left by the real estate crash stifled HELOC’s growth in a post-recession recovery, said Mary Jane Corzel, senior vice president of retail lending at Bryn Mawr Trust in Bryn Mawr, Pa.

“Before the crash, people used HELOCs for everything,” Corzel explains. “When the real estate market collapsed, they were under water. There is muscle memory in borrowers who were stuck in a bad situation back then, and who may have recovered and now have equity. People are more conservative today than before.

Understand how HELOCs work

Much of the concern consumers have can stem from a misunderstanding of how HELOCs work and who should be using one. A HELOC is much like a credit card where you get a line of credit for a set period of time, typically up to 10 years, called a “draw period”. During this time, you can withdraw money as you need.

“Instead of letting you borrow a lump sum, like a mortgage, HELOCs force you to pay only for the money you need, giving you a flexible safety net for unforeseen costs,” says Jon Giles , Senior Vice President, Home Equity at TD Bank. .

HELOC Card of the Dark Knight
Courtesy of Black Knight

You can choose between an interest-only drawdown period or a period in which you pay interest and principal, which pays off the loan faster. As you pay off the principal, your credit revolves and you can use it again until the limit expires. You then enter the repayment period, which can last up to 20 years. You will reimburse the remaining balance as well as the interest still due.

A HELOC has a variable interest rate linked to a benchmark interest rate, such as the Wall Street Journal prime rate. As the prime rate fluctuates, so does your HELOC interest rate. This means that your payments can go up or down as well, depending on the interest rate and how much you owe. Some lenders even offer a HELOC fixed rate option.

When interest rates go up, HELOCs tend to be more popular compared to the costs of a full cash refinance, says John Pataky, executive vice president and director of personal and business banking at TIAA Bank . With a credit buyback, you may need to pay off a first mortgage with a lower interest rate, replacing it with a higher rate during the life of the loan.

“It’s a much better financial result to leave the lower mortgage rate in place and end up with a blended rate situation that is much lower than what cash-out refinancing would give,” Pataky says.

Assess the risks and your financial discipline

A HELOC can be used for anything, although deductibility may be limited. The most common needs for which a person can use a HELOC include:

  • Fund home improvements that add value to your home
  • Pay college expenses
  • High Interest Credit Card Debt Consolidation
  • Buy a second property or vacation home
  • Reimburse emergency expenses (i.e. major surgery)

If you have a good read on your income stream throughout the year and are adept at managing your money, Variable Interest on a HELOC won’t be as shocking, Corzel says. If you get most of your income from commissions or bonuses and know that you will earn more in certain quarters, you can better plan your interest payments to match those increases in income, she adds.

A HELOC is not without risks. The biggest downside is that if you run into financial trouble and can’t pay off your loan, you could lose your home. Just like a traditional mortgage, a HELOC comes with service charges, terms, and interest. Lenders will look at your income, employment, assets, credit, and financial history, and order a property appraisal to determine your home’s value, Pataky says.

Not everyone who has substantial equity in their home should exploit it. Using a HELOC to finance a vacation, buy a car, or some extravagant shopping is a sign that you are living beyond your means, says McBride.

Using any home equity product that puts your home at risk requires strict discipline and adherence to a repayment schedule, says McBride. Homeowners who have no control over their expenses or debts and use their home as a piggy bank can dig a deeper hole with a HELOC.

“If credit card debt stems from a pattern of overspending that has not been corrected, then [a HELOC] is a bad idea, ”says McBride. “But if this is the result of a one-time, unforeseen event, such as medical bills or prolonged unemployment, then using a fixed rate home equity loan to minimize finance charges and have a final repayment date may be a good decision. The renewable and unlimited nature of HELOCs could invite additional borrowing and extend repayment even further. ”

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