Many people took out home equity lines of credit (HELOCs) in the housing boom glory days to buy cars, renovate their kitchens, and pay for other projects.
Now some of those HELOCs are coming back to haunt homeowners. According to financial writer Jonnelle Marte in Marketwatch, despite improving home prices, HELOC delinquency rates are actually on the rise.
What is it with HELOCs that’s getting homeowners into trouble?
The interest only trap
HELOCs normally require only interest payments for the first five or ten years. Principal might not be due until 10 years or so down the road. This can lull homeowners into a false sense of complacency. As they pay the interest diligently and pat themselves on the back for being up-to-date and on-time with their payments, they forget that principal payments are lurking out of sight, just like the iceberg that sunk the Titanic. That can lead to a very unpleasant surprise when the principal finally balloons and becomes due in its totality, or when monthly payments inflate to add principal to the existing interest repayments.
An astonishing $332 billion worth of HELOCs will start requiring principal repayments between 2014 and 2018. With perverse bad timing, those often unsuspecting homeowners could be facing stiff principal paybacks at the same time interest rates start to march upward.
Tip: Be aware that HELOC loans are not initially amortized (monthly payments during the “draw” period don’t normally include principal, so the loan balance does not reduce over the early years). If you have a HELOC, check to see when the principal is ultimately due, or when principal and interest payments start, and work out a plan in advance to pay it off. And consider paying down principal monthly, even during the “draw” or interest-only period. If you’ll eventually need to start paying principal each month, make sure you can afford the steeper principal and interest payment. If you have trouble paying interest-only now, you’ll find yourself seriously squeezed when the real repayment period starts.
The floating peril
Most HELOCs carry floating rates. The good news? Some of these interest rates have been absurdly low (we have clients with HELOCs locked in at “prime minus one,” or a current 2.25% per year). The bad news? Most these rates will float upward when interest rates climb, meaning your monthly payments will increase. If rising rates could jeopardize your capacity to pay, start thinking now about how to manage your future interest bills. You could use other funds to pay off or pay down the HELOC, combine the loan with your regular mortgage and refinance at a fixed rate, sell the house, or come up with a number of other solutions (unfortunately, many of them painful).
Tip: Do you know how your rate is computed? We routinely ask clients with HELOCs for information on the loan balance, the repayment date, and the formula for computing the floating interest rate. Most don’t know (don’t feel bad if you don’t either; I found I had “misremembered” the details of my own HELOC when I pulled it out the other day to research this story). But it’s important to be able to locate and understand the loan documents spelling out the HELOC details. What is your current rate? What benchmark is it tied to (e.g. prime, or another index)? What is the exact formula (e.g. prime minus one, prime plus two, or another permutation)? How often does it reset? How high could it go?
Escaping the quicksand
For many HELOC borrowers, the best way out is to refinance if their home will appraise high enough. Some HELOCs can be refinanced on a stand-alone basis, but many homeowners would prefer to roll the HELOC balance into the mortgage, and refinance the whole kit and caboodle. That may not have worked before because home values were too low, but now, rising home values might give homeowners enough equity to come up with a refinancing solution.
Tip: Depending on the amount of equity in your home, you may be able to combine your regular mortgage and HELOC into a fixed-rate, fully amortizing mortgage. We had been advising a couple we work with on a HELOC/mortgage refinance for well over a year without making any real progress, thwarted by their drooping home value. Then, suddenly, we had a breakthrough. Their home value picked up enough to do the deal. The payoff? They got rid of the HELOC and lowered the interest rate from over 6% to 4%, allowing them to save thousands of dollars in interest expense, eliminate the uncertainty of floating rates, and pay off the mortgage loan earlier. Another couple we worked with couldn’t get the bank to agree to anything but a full payoff of the entire HELOC balance, and they ended up having to sell investments to pay off the loan. In their case, they had planned ahead, and were able to engineer a resolution that was truly “grace under pressure.” But beware, most people put in that position wouldn’t fare so well.
HELOCs: A sharp knife that cuts both ways
HELOCs can be very powerful and flexible financial tools. They can also get the unwary into a heap of trouble. HELOCs work well when you need short-term financing and can pay off the loan fairly quickly out of your monthly earnings. But before you borrow a lot on a HELOC, ask yourself where you’ll get the money to pay it off. If you’ve already got a large HELOC balance, start reading those loan documents and work out a strategy to get it under control before it starts controlling you.