The Federal Reserve (the Fed) recently increased the target federal funds rate for the third time since the 2008 recession. Further, there are two more bumps planned for this year. While homebuyers and sellers cautiously watch for mortgage interest rates to rise in delayed reaction to the Fed’s rate increases in 2017, home equity line of credit (HELOC) users are seeing a more immediate — and visceral — impact.
HELOCs are mortgages that give homeowners access to their home’s equity as needed. Like a personal ATM built of brick and mortar, homeowners can use their home’s equity for a variety of purposes. Some uses relate to the property, like making home improvements or needed renovations. Others don’t, like covering unexpected expenses or funding a vacation (not a wise use of the funds).
HELOC users may typically withdraw funds from their HELOC for the first ten years after receiving the HELOC. During this period, payments are limited to interest only. Once the draw period is over and the HELOC resets, payments increase to include both principal and interest.
HELOC interest rates equal a set margin plus the Prime rate, which in turn is set three percentage points above the federal funds rate. Thus, when the Fed increases its target rate, the Prime rate goes up as well. It’s axiomatic. This causes HELOC payment amounts to increase — sometimes rapidly.
It takes about 30-45 days from when the Fed announces a rate hike for a homeowner to see an increase in their HELOC payment, according to Bankrate. Still, each time the Fed has announced a rate increase, it has only been by a quarter percentage point — the difference of a few dollars a month on most HELOC payments.
But these increases add up.
From December 2015, when the Fed announced its first rate increase in nearly a decade, to the week ending April 5, 2017, the federal funds rate has increased a total of one percentage point. With two more rate increases planned for 2017, by the end of the year the rate ought to be around 1.25%-1.5%. This puts the Prime rate at 4.25%-4.5%.
Not just a problem for HELOC users
HELOC interest rates will continue to steadily increase in 2017 and in the years to come. For a homeowner paying only interest during their draw period, higher rates (hopefully) won’t break the bank. However, once their HELOC resets, their already higher payments will be compounded by payments on the amount they withdrew. In tandem, this results in a potentially significant increase that may prove catastrophic to those owners who are already maxed out.
Further, when greater numbers of homeowners take out HELOCs, the market begins to feel the pressure and is at risk of overextending itself. For example, the housing crisis following the Millennium Boom had many causes, but a major contributor was HELOC over-use during the Boom. Recall the 80-10-10 piggyback mortgage of yesteryear in which the second mortgage frequently took the form of a HELOC. When HELOCs reset during the Great Recession, many homeowners, having lost their jobs and unable to refinance or sell their home due to their underwater status, were unable to make their adjusted payments. As a result, more homes were lost to the ballooning foreclosure inventory, dragging the housing market down further.
HELOCs are most popular during times of:
- low interest rates; and
- rising prices.
Sound familiar? Interest rates have been at or near historic lows since 2012, and home prices have increased in California continuously since then.
Likewise, here in California, HELOC use has steadily increased in recent years, putting the housing market at risk.
Should real estate professionals be worried?
Not yet — the key difference between HELOC use then and now is that lenders are presently more regulated and only able to lend to qualified homeowners. During the Millennium Boom, all a homeowner needed was a pulse.
Editor’s note — HELOCs are exempt from the ability-to-pay and qualified mortgage rules that govern residential mortgages made to consumers. [12 Code of Federal Regulations §1026.43(a)]
Real estate professionals can do their part to ward off another foreclosure crisis by making sure their clients read the required Truth in Lending Act (TILA) disclosures thoroughly so they are aware of the HELOC’s:
- annual percentage rate;
- payment terms;
- tax implications;
- variable rate features; and
- other miscellaneous features. [12 CFR 1026.40(d)]
The Consumer Financial Protection Bureau (CFPB) publishes a handy pamphlet that helps consumers understand and prepare for the potential hazards of HELOCs. It includes a checklist so they can compare different HELOC products, and a glossary of common HELOC terms. Better educated homeowners make better decisions.
Agents: have you seen an uptick in HELOCs recently? Are your HELOC clients worried about the interest rate increase? Share your experience in the comments!