NEW YORK (MainStreet) — Home equity loans continue to be a popular source of quick cash for homeowners, who use HELOCs to borrow against the values of their home.
According to RealtyTrac's first U.S. Home Equity Line of Credit Report, there were 798,000 HELOCs originated in the 12 months ending June 2014 — up 20.6% from a year earlier and the highest figure recorded since mid-2009.
But there's an underlying threat derived from home equity loans that borrowers may not know about, says Greg McBride, chief financial analyst at Bankrate.com: Home equity lines of credit from the days of the housing boom can sting borrowers with sharply higher payments upon reset.
With HELOCs, the first 10 years — known as the draw period — gives the borrower access to a line of credit that can be borrowed and repaid as needed. Only a minimum, interest-only payment is required. "But at the end of the 10-year draw period, the line of credit is no longer accessible and the outstanding balance then converts to the repayment term, where both principal and interest payments are made, typically over a 20-year period," he says.
A $30,000 balance at a current prime rate of 3.25% carries a minimum payment of $81.25. But, once that same $30,000 balance recasts to a 20-year repayment schedule, the monthly payment more than doubles, to $170.16. "It's this conversion from interest-only payments to principal and interest payments that could pose problems for unsuspecting or ill-prepared borrowers, particularly at a time when household budgets are still very tight and income gains have been hard to come by," McBride says.
With mortgage rates near two-year lows, many homeowners might be considering refinancing their mortgages anyway, he says. That's OK, but be careful about it, and consider whether you need to buy some time.
"One option is to wrap the HELOC into the refinancing of the first mortgage, locking in a low fixed rate on the entire balance," McBride says. "Refinancing the HELOC is one way to avoid the payment increase of a recast. This essentially restarts the clock on the 10-year draw period, delaying any payment shock, but just kicking the can down the road. The balance will eventually need to be repaid, even if it isn't until the home is sold."
Casey Fleming, a Silicon Valley mortgage advisor and author of The Loan Guide: How to Get the Best Possible Mortgage, says consumers need to get to know key HELOC loan terms to avoid recast headaches, where payments can "double or triple."
"Borrowers should fully understand the term 'index rate,' which is almost always the prime rate — the market index on which adjustments in your interest rate are based," he says. Also get to know term "ask margin" — the amount added to the index to determine your interest rate every month. "It usually isn't obvious in the marketing materials, so you have to look for it in the fine print."
"The lowest margin will be the best deal in almost every case," he adds.
Doing a better job on minimum loan repayments is another area of improvement for HELOC borrowers. "During the last housing bubble many homeowners used their home equity loans as an ATM and only made minimum payments," says Greg Cook, a mortgage consultant near Riverside, Calif. "To successfully manage a HELOC, I would recommend a homeowner determine the payment that best fits their budget — more is always better — and continue to make that payment regardless of the minimum payment required, as the principal balance drops."
In addition, always make reducing the loan principal a priority, as any reset results in the borrower paying loan principal and interest — and a higher monthly payment, Cook adds.
— Written by Brian O'Connell for MainStreet