Worried about the recent surge in home equity lines of credit (HELOCs)? Here’s what you need to know about current HELOC trends, and whether real estate professionals need to be concerned about their influence in California’s housing market.
A HELOC is a mortgage giving a homeowner access to draw on their home’s equity as needed, like a personal ATM. The typical time period during which the homeowner may withdraw their HELOC funds, called the draw period, is ten years. During the draw period, HELOC payments are limited to interest — no principal is repaid. Further, HELOC payments can be made with HELOC funds (a dangerous precedent).
Once the draw period ends, the HELOC resets and the homeowner’s payments increase to include interest and principal, or in some cases a final balloon payment. Further, the interest rate is variable, and will adjust upward with its benchmark index rate.
HELOC use continues to increase here in California. The year-over-year percent change in HELOC originations as of mid-2016 was:
- +27% in Sacramento;
- +15% in Fresno;
- +12% in San Jose;
- +8% in San Diego;
- +2% in Riverside-San Bernardino; and
- +2% in Los Angeles, according to RealtyTrac.
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 2016’s increased HELOC use is a less volatile increase than seen in recent years, the fact that HELOC use continues to increase at all — particularly following the negative reputation they received following the Millennium Boom — is notable.
Why did homeowners increasingly turn to HELOCs in 2016?
A study published in the American Economic Review finds 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.
Since HELOC rates are higher since 2015, the cause of increased HELOC use lies elsewhere.
The American Economic Review study also identifies 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. Here 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%.
Is the home price increase the sole reason for the rise in HELOC use? Or is there something else going on here — and more importantly — should real estate professionals be worried?
The hazards of HELOC overuse
Too many homeowners taking out HELOCs contributes to a destructive housing trend. The popularity of HELOCs during the Millennium Boom proved disastrous for many HELOC homeowners. The negative effects rippled throughout the housing market for years, contributing greatly to the foreclosure crisis, from which we finally recovered 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 forecasted 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.
Still, some caution is warranted when a client approaches you wondering if they ought to take out a HELOC to finance whatever projects they have in mind.
The varied uses of HELOCs
The reasons a homeowner may take out a HELOC include:
- to make home improvements which will substantially:
- increase the home’s value;
- prolong the property’s useful life; or
- adapt the property to residential use;
- to start a business;
- to cover education costs; and
- to pay for other various non-housing related expenses.
Despite the risks, sometimes it makes sense to take out a HELOC. Financing home improvements that will increase the home’s value is a particularly good use of the funds. But your clients need to be cautioned away from withdrawing HELOC funds to pay for vacations, jet skis or other miscellaneous things they will pay hard for later. Just because they can doesn’t mean they should.
Further, how a homeowner uses their HELOC funds can change the nature of the loan.
HELOCs funding substantial home improvements are nonrecourse debt. When a homeowner defaults on a nonrecourse debt and the lender pursues foreclosure, the lender is unable to 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 to fund any other purpose are recourse debt. For this type of debt, the lender has the option 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 your HELOC clients
When a client comes to you unsure about what to do when their HELOC resets and the payments jump beyond their ability to pay, they have a few options:
- 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.
- They can refinance into another HELOC. This is not ideal, since it kicks the can down the road a bit without actually solving the root of the problem. Further, this is only possible for those with positive equity in their home.
- 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.
Share these tips with your clients considering a HELOC. Also check out the Consumer Financial Protection Bureau’s (CFPB’s) helpful pamphlet outlining the pros and cons of taking out a HELOC. For clients determined to take out a HELOC, the pamphlet also includes tips for shopping around for the best rate and terms. [See RPI Form 312]