Cautionary Advice on Getting a Home Equity Line
Banks are pushing HELOCs, but they might not mention something
Since home buying has sputtered, banks are feverishly pushing home equity lines of credit (or HELOCs) to homeowners whose properties have regained much of the value they lost during the housing bust. “Lenders are opening up their spigots,” Sam Khater, deputy chief economist at CoreLogic, a mortgage-data firm, told The Wall Street Journal. Should you bite?
“Home equity borrowing is regaining appeal in an environment of increasing home values and continued low interest rates,” says Greg McBride, Bankrate.com's chief financial analyst. “For savvy borrowers, this can be a low cost source of funds for home improvement projects or other needs.”
It’s true, now that rates are relatively low for the ability to tap your home equity for any purpose (often 4 to 7.25 percent; the interest is generally tax deductible), HELOCs are tempting. But I’d recommend exercising caution before getting one — and I’m speaking from personal experience.
If you’re not careful, you could end up borrowing more than you actually planned and find yourself saddled with a pretty hefty loan when payback time comes.
How a Home Equity Line Works
A brief primer on HELOCs, before I get to my experience with one and provide advice for you:
A home equity line of credit works a bit like a credit card. You get a variable interest credit line of up to a certain dollar amount and can tap it as often as you like. You generally pay interest only for up to 10 years, what’s known as the “draw period.” After that, you must begin paying back interest and principal. The amount you can borrow — typically ranging from $10,000 to $1 million — depends on things such as the value of your home, how much you owe on your first mortgage and your credit score.
One wrinkle for 2016: You might have a harder time getting approved than in, say, 2005. That’s because lenders are now requiring higher credit scores. The average credit score for HELOC borrowers in 2015 was 774, more than 30 percent higher than a decade ago, according to CoreLogic. In addition, lenders have grown more conservative about how much they’ll lend. Today, the average HELOC loan-to-value ratio is just over 60 percent. That means if you have a $200,000 home and $95,000 left on your mortgage, for instance, your maximum home equity credit line would be about $25,000 ($95,000 plus $25,000 divided by $200,000 = 60 percent).
Our Home Equity Line Shocker
Now here’s what happened to me, which is one reason I urge caution regarding HELOCs:
Last fall, my husband was practically tackled in our bank’s branch by a loan officer and given a breathless sales pitch for taking out a HELOC on our Washington, D.C. house. The application process would be simple as pie, my husband was told. There’d be no closing costs and the interest rate would be under 4 percent.
We’re both freelancers, so it surprised me that we’d be so sought after. That said, we’ve been customers of the bank for nearly 25 years and the institution holds our primary mortgage, which is nearly paid off, I’m happy to say. We weren’t hankering for a home equity line, but I liked the idea of ready access to cash someday if we had a catastrophe like a medical crisis. So I told my husband that I was on board with this, if he was.
We filled out the application and zapped to the bank our financial statements plus our accountant’s verification of our income. Easy peasy, we thought. Then, we were stunned when it came time for the closing: the bank was requiring us to take an immediate draw of $25,000 and we had to agree to automatic debit payments each month from our checking account, starting in one month.
I raised the roof (you don’t want to be there when that happens). The lending officer said those stipulations had been in the documents we’d been sent, but somehow neither of us had noticed the fine print. But, I told the banker, we didn’t need a $25,000 loan now! “Oh, you can just pay it back right away,” she reassured us. I felt oddly violated, leaving the bank with a bad taste in my mouth and my stomach in knots.
The instant I saw that 25K hit our checking account, I transferred it right back to the credit line. But seriously, how many people don’t pay the immediate draw back so quickly? My guess is banks count on them not to, so the institutions get hefty interest payments fast.
3 Tips Before Signing Up for a Home Equity Line
I’ve made peace with the process, but since it raised a bunch of red flags for me, I wanted to share them with you with some advice. If you’re shopping for a home equity line, here are three important things to consider:
Be careful about what you’ll use the home equity line for. It’s seductive to tap the equity for a renovation or a vacation of your dreams. But, McBride cautions: “The usual caveats apply about not borrowing for consumption items — like vacations or new toys — and understanding that the collateral is your ownership stake in the home, making the consequences of default significant.”
Scrutinize the credit line’s terms and interest rate. These can vary dramatically among banks, credit unions and mortgage companies. Bankrate.com has a handy rate roundup to compare what lenders are charging in your area.
“Be mindful that this is a variable rate product, and money you borrow today could well be paid back at a higher interest rate later,” notes McBride.
As Citibank advises on its site: “It is important to remember that when your repayment period begins, your minimum monthly payment is likely to increase significantly.”
Watch out for hidden fees, too. While many HELOC ads tout no closing fees, there may be appraisal fees and an ongoing annual fee of $50 or so.
Devise a plan to pay it back. I recommend that you pay back more each month than the required minimum interest payment, just as I’d recommend for a revolving credit card with a minimum monthly payment.
Set a dollar figure (maybe $500 a month) and pay that extra amount on top of the automatic minimum; you can tweak how much extra to toss in each month, depending on your cash flow. Just make it a habit to systematically whittle down your principal balance. Once you need to start paying the principal balance, that monthly expense can multiply quickly — especially if interest rates have risen.
To get a sense of what those payments might ratchet up to after your line of credit period ends, run the numbers on a home equity line payoff calculator like this one at Bankrate.com.
One parting thought: Just because lenders are loosening up the reins on their home equity credit lines and offering what looks like a bargain initially, this is not what I would call a gift horse. You should look this one in the mouth.