raises interest rates this summer, among the first to feel the pinch will be the nation's homeowners who've tapped their homesteads for cash.
Home-equity lines of credit, also known as HELOCs, have been around for 18 years but became a hot product only in the last several years with rates at historic lows.
"They're really going gangbusters," says Fritz Elmondorf, vice president of communications at the Consumer Bankers Association in Arlington, Va., which represents the nation's largest retail banks.
Financial institutions insured by the FDIC report that home-equity lines of credit grew from $151 billion in 2000 to $346 billion in 2003, an increase of 129% (see chart).
Their popularity and ease of access has prompted some to warn that widely expected rate hikes could cause the sky to come crashing through the roofs of HELOC homeowners. But more reasonable voices say most home-equity debt has actually helped many homeowners "restructure their debts," and that they'll manage to cope when rates rise.
HELOCs are currently giving consumers what seems like the deal of a lifetime -- the chance to borrow at 3% or 4% for 10 years or more on homes that has increased in value by as much as 50% or even 100% in just the past few years.
Major lenders promote the lines heavily.
Wells Fargo & Co.
, for example, encourages homeowners through mailings to come speak with a "home asset specialist" who can "work with you to find the Home Equity Account that fits your needs."
HELOCs allow homeowners to borrow against their home equity (the home's value minus secured debt against the home) using a revolving line of credit like a credit card. Many lenders will waive all fees, including the cost of an appraisal, which in some cases is done by computer in a matter of seconds rather than by an individual.
Unlike credit cards, HELOCs charge lower rates of interest, currently between 4% and 6%, and the interest in many cases is tax-deductible. On the down side, a HELOC is secured by the house, and failure to pay could result in foreclosure, which wouldn't happen with a credit card.
The Tax Reform Act of 1986 phased out the deductibility of interest on credit cards and auto loans, but left it in place for mortgages. Interest on HELOCs can be deducted on loans up to $100,000, under strict IRS rules (see IRS Publication 936), which is part of their appeal.
Rates on most home-equity lines are variable, not fixed, and are tied directly to the prime lending rate, now at 4%. Some are slightly below, some are about 1 percentage point above. So if the Fed raises rates by a quarter or a half of 1 percentage point, rates on HELOCs will follow in lockstep.
Take, for example, a $50,000 home-equity line in which the homeowner has borrowed to the maximum and now has 10 years to repay at a current rate of 4%. The homeowner's monthly payments are $506.23, including principal and interest.
If rates nudge up by 0.25%, the monthly payment rises to just $512.19. With a 0.50% increase, it goes to $518.19. And a 2 percentage-point hike in one year, typically the annual maximum increase allowed on most HELOCs, or 6% in that case, would make the payment grow to $555.10.
On the House
*Loans from FDIC lenders only.
Because most HELOCs are relatively small amounts, compared with first mortgages, many homeowners should be able to take the rate increases in stride. The loans can run as high as $500,000, but the average loan amount last year was about $36,000.
Homeowners, however, should be aware of a little-known fact about HELOCs: They have the potential to rise along with interest rates up to 18% and in some states as high as 22%.
The limits are set by each state's usury rate, which can run pretty steep, says Keith Gumbinger, vice president of HSH Associates, financial publishers in Pompton Plains, N.J. Of course, it would take years to get to that point and many other aspects of the economy would change dramatically as well.
"There's not a whole lot of reason to get nervous," acknowledges Gumbinger. "But while rates remain low, it might not be a bad idea to pay your line down now and keep your payments the same."
A report published in January by the Federal Reserve Bank of New York looked at equity withdrawal through the refinancing of mortgages and whether "the wave of home equity withdrawal has fueled a substantial net increase in consumer spending while eroding the household balance sheet."
It concluded that households are quite sensibly using low-cost, tax-advantaged debt to make many of the same purchases they would otherwise. While mortgage loans are higher, because of lower interest rates, debt payments are actually absorbing a smaller share of household after-tax income.
There's no doubt, however, that some homeowners have abused the easy access to cash that equity lines have provided. They have racked up large credit card debts, paid off the cards with a HELOC, then turned around and done it again. They could easily lose their homes should rates rise and home prices cool quickly.
"Anybody who doesn't manage their debt wisely isn't a candidate for a home-equity line," says Gumbinger.
It's difficult to determine just how many home-equity loans are currently open. They are offered by banks, as well as nontraditional lenders such as
, or www.eloans.com, and www.loanhounds.com. And homeowners can be continually increasing and decreasing their revolving lines.
Homeowners take out HELOCs for a variety of reasons. The traditional reason is to consolidate debt, buy a car, pay for college and, yes, expand or improve a home (see chart).
In recent years, first-time buyers have been using them in two ways: as a piggyback loan to their first mortgage so they can afford to buy a home, or as a piggyback to avoid paying mortgage and insurance, or PMI, payments.
Another increasing common use for them is "rainy day" insurance for an extreme emergency like an unexpected job layoff or medical emergency. Many financial advisers recommend that all of their clients take out HELOCs while they are employed, then put the credit card and checks in a drawer, to be used in the event of job loss. Although the basis for the line of credit is the equity in the home, lenders will not issue a new loan to someone who is unemployed.
A recently emerging HELOC use, says Elmendorf, is by homeowners who have only a few years left on a mortgage at 7% and have thus chosen not to refinance because they were close to paying it off. So, they use the money they borrowed at the HELOC's lower rate to pay off the mortgage, which has a higher rate.
"It's kind of new, but it's happening quite a bit," he says. "It's a good play."
The danger from HELOCs for most homeowners isn't from immediate rate hikes, but from poor long-term financial planning.
It can be a good decision for parents to use a home equity line to finance a portion of their children's college expenses if it can be paid off early in retirement. But it makes no sense to stretch out what should be a four-year or five-year car payment or a weekend vacation into 10-year debt, even if it might be tax-deductible.
Of course, the reality is most people pay off their lines of credit before the due dates anyway, because they sell their homes. The average homeowner moves every seven to nine years, says Elmendor.
But for baby boomers who've settled into that last, comfortable move-up home with lots of appreciation, there could be danger in loading up with lots of home-equity debt to finance cars and college.
They shouldn't assume there will be plenty of buyers when the time comes to downside after the kids move out of the house. Values will probably hold in prime locations, but the generations following boomers are much smaller, and might not be capable of buying all those move-up houses at top dollar.
(For more information on HELOCs and how to shop for them, HSH offer a booklet called
A Homeowner's Guide to Home Equity Loans and Lines of Credit
for $4 including postage and handling available at http://www.hsh.com/heloc-announce.html.)