After getting a bad rap over the last decade or so, homeowners are once again saying hello to the Home Equity Line of Credit (HELOC).
Between 2012 and 2016, the number of new HELOCs climbed for 17 consecutive quarters, showing a steady rise in confidence for the loan type.
The rise in HELOC popularity is expected to continue as well, especially since the housing market has been growing steadily over the past five years.
The revived popularity of HELOCs is due in part to their lower costs compared with cash-out refinances, as well as their flexibility with using the funds you withdraw.
This Time, Homeowners Play it Smart
HELOCs are basically revolving credit accounts that let you withdraw any amount up to your limit. You’re allowed to pay it down, or pay it off completely, at will.
HELOCs have two phases: the draw period and the repayment phase.
In the draw period, you use the line of credit as much as you want, meaning you “draw” funds out. During the draw period, your minimum payment goes to cover just the interest rate that is due.
When the HELOC draw period ends, your loan enters the repayment phase. At this point, you can no longer draw funds and the loan becomes fully amortizing over its remaining years, meaning you begin to make payments on both the interest and the loan amount.
While HELOCs may have caused some trouble for homeowners in the past, today’s homeowners are smarter about how they spend the money from their HELOCs.
One reason homeowners use HELOCs is for finance home improvements. Not only does this make your home nicer to live in, but it often increases the value of your home in the event that you choose to sell it.
Some people are even using HELOCs to refinance their primary mortgages in order to avoid the closing costs associated with other types of mortgage loans.
Another reason for the HELOC trend is that people are staying in their homes for longer periods of time than they used to.
Instead of taking out a new mortgage to pay for a larger house, homeowners are using HELOCs to finance improvements or upgrades.
Because more homeowners are using HELOCs to invest in their current homes, and because regulators and financial institutions have imposed stricter lending standards since 2008, it’s unlikely that a substantial number of homeowners will find themselves “underwater” if housing prices fall.
Even so, it’s important to carefully weigh the risks and rewards of obtaining a sizeable loan, especially one secured by what’s usually your most valuable asset – your home.
How High Will HELOC Rates Jump?
While mortgage rates don’t always respond to hikes in the Fed’s rate, interest rates on HELOCs usually rise with their rate.
Because the Fed has raised their rate three times in the last two years, HELOC rates are likely heading higher. How high rates will go is anyone’s guess, but it may be prudent for some homeowners to take action if rates rise too high.
For example, if you plan to remain in your home for a few more years, consider refinancing your HELOC into another type of fixed-rate loan.
If you don’t want to give up your HELOC, talk with your lender about converting a portion of the variable-rate credit line into a fixed-rate loan.
Many HELOCs let you convert the adjustable-rate debt to a fixed-rate loan if you want to lock in a specific rate. This often occurs automatically once you enter the repayment phase, but many HELOCs also allow you to convert your loan balance to a fixed-rate whenever you want.
You could also warp the HELOC into a first mortgage refinance.
If the interest you pay for your first mortgage and your HELOC exceeds what you’d pay by combining them into a single first mortgage, refinancing makes sense. Keep in mind, however, that most lenders consider this a “cash-out” refi, and the costs are higher.
Some HELOCs have rate caps limiting how much interest the lender can charge. Check your loan agreement to see whether your HELOC has a cap, and if so, how high the rate could climb.
Still a Great Deal
For the time being, HELOCs remain one of the least expensive loans on the market, especially compared to personal loans and credit cards. Also, because the HELOC is a type of mortgage, the interest paid is tax deductible for borrowers who itemize.
A couple filing jointly can deduct the interest on up to $100,000 in home-equity debt, while individuals can deduct interest up to a maximum of $50,000.
Unlike credit cards, HELOCs rarely charge check-writing fees (or cash-advances). If you encounter one with such fees, you should probably walk away.
Remember, though, that some lenders don’t require you to repay any principal during the HELOCs draw period.
So if you borrow more than you originally anticipated or make only the minimum payments during this period, you could receive an unpleasant surprise when the repayment phase begins.
At that point, your monthly payments could rise from tens of dollars to hundreds of dollars a month, so be careful not to overextend yourself.