Return of the HELOC, What it Means for Homeowners

Piggy bank

Rising interest rates, rebounding home prices and improving consumer confidence has brought the return of home equity lines of credit.

Known as HELOC, these loans use the equity in the house as collateral to lend homeowners money, typically at a lower interest rate than other borrowing options.

During the housing bubble and ensuing recession, the credit markets froze, forcing many homeowners to sideline home improvement projects that required a loan.  Now, with the economy on the mend, home values increasing and banks ready to lend, there’s a resurgence of HELOCs.

“The sizes of the loans are 10% larger than a year ago,” says Rick Huard, senior vice president, consumer lending product management at TD Bank. That increase comes is in line with the increase in home values over the last couple of years, he explains.

In order to qualify for a HELOC, lenders expect at least 20% equity in a home. Some are more lenient with 10% equity, but that loan will come with a higher interest rate.

Another option for homeowners is a home equity loan. On a line of credit, the interest rate is variable, which means it changes with the interest rate environment. The rate on a home equity loan is fixed.  With a line of credit the borrower draws down money on an as-needed basis, making it ideal for home improvements. With a home equity loan, the money comes in one lump sum.

“The benefit of a home equity loan is the comfort of knowing the payment is not going to change,” says Richard Bettencourt, branch manager at the Mortgage Network in Danvers, Mass.

He adds that borrowers have a higher interest rate with the loan opposed to the line of credit. “Sometimes a home equity line of credit can be more favorable if you are not concerned about the rate fluctuating.”

While no one is predicting interest rates will shoot up in the near term, it is something to consider when choosing between the two products. When making the decision, Bettencourt recommends keeping in mind that with a line of credit, the borrower gets a bill each month for the interest only, but they’re expected to make payments to the principal as well, says Bettencourt.

Once the loan converts to interest and principal payments in 10 years, homeowners will face a much greater monthly bill if they hadn’t been paying down the principal.

Choosing the best loan depends on the homeowner’s financial situation, plans for the money and fiscal discipline. According to Jeffrey Taylor, managing partner of outsourced mortgage processing and data analytics firm Digital Risk, the most common reasons to borrow against the equity in a home is for home improvement projects or to pay down high-interest debt like credit cards.

Some people will take out the line of credit to cover an emergency or unexpected bill, and that’s where he said the discipline comes in. “What people have to be wary about is using their house as a ATM machine or for lifestyle type products like trips or other things there is not a quantifiable return on the investment,” says Taylor.

One of the reasons so many people got in trouble leading up to the housing crisis was they used the equity in their home as credit card to make frivolous purchases. When home values started plummeting when the bubble finally burst, many borrowers couldn’t afford to pay back their home equity lines of credit or make their loan payments, which resulted in many short sales and foreclosures.

As a result of the loose lending standards in the early 2000s that led to the 2008 financial crisis, many lenders have made their approval process more stringent. Now, the interest rate attached to a loan depends on the borrower’s credit score and the amount of equity in the home.

When shopping for a home equity loan or line of credit, experts recommend starting with the bank that holds the mortgage.  If the rates match up with other lenders, often the approval process is much speedier because the bank already has all the requried financial information.

Every homeowner should shop around for the best lending rates—paying particular attention to fees.

“Comparing the rates in number one and number two are the closing costs, which most organizations shouldn’t have,” says Huard of TD Bank. “The third thing to look at is the annual fee.” He notes most lenders charge an annual fee of $50.