For millions of Americans, home equity lines of credit (HELOCs) have been a convenient, low-cost ways to finance home improvements and consolidate debt and big-ticket purchases such as cars and college educations.
But there’s a problem – a problem of “collective amnesia.”
HELOC recipients tend to forget that the moment their loan’s 10th anniversary arrives, the revolving line of credit will evaporate and (worse) the modest monthly payments are likely to skyrocket, sometimes doubling or even tripling in size.
That’s because HELOCs come in two stages.
Stage #1 is the “draw period,” usually 10 years but sometimes as long as 20 years, during which monthly repayments tend to be interest-only.
Stage #2, also 10 years in most cases, is the “repayment period” (or “amortization period”). Once this arrives, monthly payments often rise precipitously because they now include both the loan’s interest and principle.
With a HELOC of $30,000 (assuming a three percent interest rate and 20-year repayment period), this could cause the monthly payment to jump from just $75 to $166.
More than 3 million households owing a total of $158 billion on HELOCs are now entering the repayment period or will enter it in 2018. Some of these homeowners are “under water.”
The 3 Best Refinancing Options
Of course, once the amortization begins, you could simply accept that the “other shoe has dropped,” and start making the higher payments.
For many homeowners, this isn’t an attractive option. Instead, they choose one of these three refinancing options to ensure continuing access to credit and/or reduce the size of their monthly payments.
Apply for a new HELOC
The most popular option is to get a new HELOC to pay off the old one. This allows you to start over with a new draw period and retain your line of credit for future needs.
If your credit score has improved or if interest rates have declined since your last application, you may even qualify for a lower rate. (The vast majority of HELOCs come with variable interest rates.)
On the other hand, you will still have to pay off the loan eventually, so getting a new HELOC merely delays the inevitable.
Additionally, you’ll probably encounter much stricter lending standards than you did 10 years ago. In other words, qualifying for a new HELOC is hardly a sure thing.
At a minimum, you’ll probably need to supply more financial documentation than you did last time, including recent paycheck stubs, W2 statements and tax returns.
You may also need a higher equity-to-loan ratio to qualify than you did during the real estate boom of the mid-2000s. Although some lenders let homeowners with excellent credit borrow up to 90 percent (or even 100 percent) of their home’s value, most allow homeowners to borrow only 80 percent.
Get a home equity loan
Unlike a HELOC, a home equity loan is not a revolving credit line, but a lump sum of money.
The advantage of this kind of loan is that your payments never increase. Instead, you pay a fixed monthly sum consisting of both interest and principle for the life of the loan.
Because most home equity loans come with fixed interest rates, it’s a good idea to take advantage of today’s lower fixed rates. In addition, home equity loans usually have much lower closing costs than regular mortgages.
Refinance into a new primary mortgage
Using this option, you refinance both the HELOC and your first mortgage in into a single new loan. As with home equity loans, a new mortgage comes with equal monthly repayments – and no sudden increases.
Another advantage is that the interest on first-mortgages is often lower than for home equity loans because, in the event of a default, the first-mortgage lender is the first to be paid back from the proceeds of a home foreclosure sale.
As noted above, though, the main disadvantage of this refinance option is higher closing costs.
However, if you plan to stay in the home for a while, those costs can be more than offset by the lower interest rate. In that case, your total monthly savings should eventually outweigh the costs of the refinancing.
If All Else Fails …
If you don’t qualify for these refinancing options because you don’t have enough equity in your home, your credit score leaves something to be desired, or you’re otherwise financially distressed, there’s one more option you could pursue: ask your lender for a loan modification.
If you determine that your monthly payments during the amortization period will be more than you can reasonably afford, contact your mortgage lender as soon as possible and ask if it can arrange an extended payment schedule or another type of loan modification.
Rather than risk a default on the loan, many lenders will agree to a loan modification that (for example) extends the interest-only period of the HELOC for another five or 10 years.
Keep in mind, though, that banks and other financial institutions are not obligated to modify their loans, so it’s best to never get yourself into a position where this is your only refinancing option.