Surely, nobody needs reminding of our tough climb back since the real estate market went over a cliff around the mid-2000s (we’ve still got a lot of climbing to do, of course).
The good news for homeowners is the recovery from recent years is expected to continue in 2015. As prices climb, the capacity of homeowners to borrow against their homes, in theory, also increases. In recent years, there has been stepped-up interest in home equity lines of credit, or HELOCs, over traditional home equity loans. Why? Interest rates for HELOCs are typically lower.
In late 2014, HELOC rates were around 3.25%, and in some cases as low as 2.75%. By comparison, fixed-rate home equity loans were 5% to 7%. A no-brainer right? Well, there's always more to consider before signing on the dotted line. It’s important to understand how these vehicles work, and get a handle on the longer-term path for interest rates in general.
According to Mike Kinane, Senior Vice President of Retail Lending Products at TD Bank U.S., about 90% of clients in recent years chose HELOCs over home equity loans.
Home equity lines are a lot like a credit card with a high credit limit. Once a line is approved, homeowners can borrow on as-needed basis. Typically, there is a 10-year “draw” period during which the homeowner can borrow. At the 10-year mark, the draw ends and the loan amortizes for 20 years.
But take note: Home equity line rates “float,” meaning they change depending on the “prime” rate, a longstanding benchmark used by banks (by contrast, fixed loan rates are just that—fixed at the same rate).
The prime rate currently is around 3.25% (see figure 1). Rates may be low now, but that’s widely expected to change in 2015 as the Federal Reserve dials back its economic stimulus efforts.
By around the middle of 2015, many Fed-watchers expect the central bank to hike its fed funds rate (currently targeted at 0-0.25%) for the first time since 2006. Rates on most everything else—mortgages, credit cards, and so on—probably will follow suit. An increase of 0.5 percentage points in the funds rate, for example, would likely push the prime rate up by a similar amount.
For anyone considering a HELOC, “you have to think, can I still make this payment in a rising interest rate environment?” Kinane said. For perspective, during the mid-2000s, when the prime rate was above 8%, HELOC rates were in the range of 9-10%.
How much can you borrow? Generally, HELOCs are based on an 80% of loan-to-value ratio. For example, your house is valued at $200,000 and you have a first mortgage of $100,000; 80% of $200,000, minus the amount owed, comes down to a $60,000 equity line.
Ultimately, remember that debt is debt. Home equity lines are secured by your humble abode, which makes these vehicles different from unsecured credit-card debt. With credit cards, if a consumer misses a couple of payments, the credit card company can't take away their home.
“Customers are borrowing on their home,” Kinane said. “Think carefully about this type of debt. If (homeowners) lose their job or don't have the ability to repay, it could lead to foreclosure.”
There are key differences between home equity loans and lines of credit. HELOCs have been the more popular avenue in recent years, but with rising rates on the horizon in 2015, it might be time for homeowners to take a closer look at home equity loans as an alternative.
Check Ticker Tape Personal Finance Perspectives in coming weeks as we dive further into these instruments.