NEW YORK (MainStreet) Tolerance for home equity lines of credit is returning, despite playing a role in causing the 2008 mortgage.
Credit reporting agency Equifax reports home equity lines of credit, known as HELOCs, have risen 8% year-to-date as of February, representing a five-year high.
In the years leading up to the 2008 financial crisis, HELOCs were a helpful tool for consumers, as they allow homeowners to tap into their home's equity like an ATM to be used for home improvements, college tuition or paying off credit card debt.
As long as home prices were rising, which they were, homeowners could fully take advantage of this unrealized wealth known as equity.
When the housing market crashed, homeowners found themselves in over their heads, as primary mortgages and home equity lines of credit started to exceed the home's value.
While plenty of measures have been taken by lawmakers to prevent a future recession, consumers and banks still haven't learned their lessons. HELOCs remain a risky financial tool that puts you at risk for foreclosure should you be unable to pay back the funds drawn from the line of credit. Banks are also incentivizing higher HELOC amounts by offering lower interest rates.
"The CFPB [Consumer Financial Protection Bureau] added regulations for the traditional mortgage market, but not for the HELOC market," says Dani Babb, founder and CEO of The Babb Group.
For consumers looking into HELOCs, there are plenty of things to watch out for. First, be aware of the fees involved, which typically include an appraisal fee, an application fee to run your credit and a closing fee, which can range from a percentage of the HELOC amount or a flat fee.
"Ask the lender if they'll refund the application fee if your credit is too low and you're denied for the HELOC," Babb says. Otherwise, you'll be paying upwards of $300 for nothing.
Next, the interest rate on a HELOC can be fixed or variable. Make sure you're clear on what the lifetime cap on the loan is if you're taking out a variable HELOC. The lifetime cap is the maximum rate the loan can adjust to. "During the recession, some loans had a 2% rate, but a lifetime cap of 10%, which would make the payments unaffordable for many people if the loan adjusted to or close to that level," Babb warns.
Plus, the economy is in a rising interest rate environment, as the Federal Reserve winds down its bond stimulus, which has kept interest rates low, and considers raising short-term interest rates.
Babb suggests using online calculators to determine the monthly payment of the HELOC should the rate adjust to its cap.
Some lenders want to give you a HELOC large enough to also pay off your primary mortgage. If you're looking for a HELOC for $30,000 and your primary mortgage is $300,000, you may be presented with a line of credit for $330,000. "The lender wants to be the new mortgage holder, but they call it a HELOC because there is less regulation," Babb says.
With HELOCs, there is a draw period, in which you are able to access the cash of the HELOC while simultaneously paying interest. There is also the repayment period, where the access to funds closes, the interest payments continue and principal payments start to kick in. Another potential HELOC trap is the balloon payment that some have at the end of the repayment period. This is where you'll have to repay the remainder of the HELOC amount, plus interest during the very last payment, which can be unaffordable for many.
"Ask the loan advisor if the HELOC has a balloon payment," Babb advises.
- Written by Scott Gamm for MainStreet. Gamm is author of MORE MONEY, PLEASE.