26 Nov The down-low on HELOCs
The use of home equity lines of credit (HELOCs) continue to increase year over year. Here’s what you need to know about their influence in the California housing market.
A HELOC gives a homeowner access to draw on their home’s equity as needed, much like a personal ATM. The period where they may withdraw on their HELOC funds (the “draw period”) is ten years. During this time, the HELOC payments are limited to interest only (no principal is repaid). In addition, HELOC payments can also be made with HELOC funds, which can lead to trouble down the line.
After the draw period of ten years, the payments increase to include interest and principal. Alternatively, it could result in a final balloon payment. In addition, the interest rate is variable and will adjust upward with its benchmark index rate.
In San Dieog, HELOC use continues to increase (up 8%), but not quite as much as other parts of California. The year-over-year percent change in HELOC originations (according to RealtyTrac) as of mid-2016 was:
- +27% in Sacramento
- +15% in Fresno
- +12% in San Jose
- +8% in San Diego
- +2% in Riverside-San Bernardino
- +2% in Los Angeles
San Francisco was the only California metro area to see a slight decline in HELOC use, which was 0.2% less than a year earlier in mid-2016.
While the increased use of HELOC isn’t less than as it has been in recent years, it’s surprising that there is even an increase, especially due to the negative reputation among the Millenium Boom.
Why did the use of HELOCs increase in 2016?
The American Economic Review published a study that concluded that HELOC use rises significantly with falling interest rates — since lower rates coincide with lower payments for the same equity withdrawal, or higher withdrawal possibilities with the same payment amounts as the previously higher rate. However, during the same period of increased HELOC use from mid-2015 to mid-2016, benchmark interest rates (like the London Inter-Bank Offered Rate (LIBOR) and the Prime rate) which control most HELOC rates actually increased.
But…since HELOC rates are actually higher since 2015, the cause of the increase must be originating from somewhere else.
That same study also points to rising home prices as a key motivator in HELOC use. Since the amount of credit available through a HELOC is based on a percentage of home equity, as equity increases so does the amount a homeowner is qualified to withdraw.
In California, low-tier average home values have increased at a steady 10% year-over-year rate since 2015, while mid- and high-tier values have increased at an annual rate of about 5%.
Are increased home prices the main reason for the rise in HELOC use? Or is there something else going on here — and more importantly — should real estate professionals be worried?
Having so many homeowners taking out HELOCs leads to a destructive housing trend. During the Millenium Boom, the popularity of HELOCs was disastrous and those negative effects were felt throughout the market for years afterwards. This contributed greatly to the foreclosure crisis that we finally recovered from in 2014.
A 2014 Transunion study found that 11%-19% of homeowners with a HELOC balance are at risk of default once their payments reset. They also predicted that this percentage will decrease as the years go on and incomes rise. Therefore, the share of HELOC borrowers at risk is likely lower today than forecasted in 2014.
Uses of HELOCs
The reasons a homeowner may take out a HELOC include:
- to prolong the property’s useful life
- to make home improvements that will increase the home’s value
- to adapt the property to residential use
- to pay for other various non-housing related expenses
- to start a business
- to cover education costs
Although there are risks, there are times that it does make sense to take out a HELOC. For instance–using the money to do home improvements that will increase the homes value. However, using HELOC to pay for personal travel and entertainment is a different story and may lead to complications down the road.
It’s also important to note that the way in which a homeowner uses their HELOC funds can change the nature of the loan.
HELOCs funding substantial home improvements are non-recourse debt. When a homeowner defaults on a non-recourse debt and the lender pursues foreclosure, the lender cannot pursue the homeowner for additional money when the proceeds from the foreclosure sale don’t cover the amount owed on the debt. Thus, this type of HELOC is ultimately a safer use of funds.
However, HELOCs used for any other purpose become recourse debt. For this type of debt, the lender is able to judicially foreclose and pursue the homeowner for the additional funds when the foreclosure sale doesn’t cover the amount due. [Calif. Code of Civil Procedure §580b]
Advice for HELOC users
When HELOC resets and the payments jump beyond a client’s ability to pay, there are a few options:
- Best Option: They can bite the bullet and find a way to make the increased payments. The good news: if they start saving up early by putting away more each month until they reach the full amount of the reset payment, the payments won’t come as an unbearable shock to their finances when they occur.
- Less Than Ideal Option: They can refinance into another HELOC, but this is not necessarily a good idea. It basically just kicks the can down the road without actually solving the problem. Additionally, this is only possible for those with positive equity in their home.
- Worst Option: They can default and allow the lender to foreclose on their home. This is the least ideal option, since they lose their home. This is an even worse option for a HELOC (ab)user who used their HELOC funds for things other than substantial home improvements, since the lender has the option to pursue them personally for the funds spent.
For more information, check out the Consumer Financial Protection Bureau’s (CFPB’s) helpful pamphlet outlining the pros and cons of taking out a HELOC, or contact me, and I’d be happy to answer any questions and advise you on the best course of action.