As Homeowners Tap Their Equity, Who Wins and Who Loses?

by Ethan Roberts | June 3, 2013 9:58 am

The housing market was recently showered with more good news, namely, a 10.9% year-over-year increase in nationwide home prices.[1] And with rising prices, of course, comes the desire for countless owners to tap into their home equity.

There are a few ways to do this. With a home equity loan, you receive money in one lump sum, and there may be closing costs to pay. The interest you pay is fixed for the life of the loan and it is generally tax deductible.

By contrast, a home equity line of credit (HELOC) is a variable rate that is pegged to the current prime rate. There are usually no closing costs. The money can be taken when needed, although there may be an initial draw required within the first few weeks.

The interest rate is usually lower than that of a loan, and the interest is still tax deductible. There is often a time limit on the life of the HELOC, such as 10 or 15 years, and there may be a balloon payment due at the end of that term.

With the basics out of the way, let’s get to the question on everyone’s mind: Is the trend of tapping back into home equity a good thing?

Well, as with most trends, there could be winners … and losers.

The current national average for a $30,000 home equity line of credit is 4.99%, while the national average home equity loan is 6.20%. Interest rates usually decrease as the loan amount increases.

With interest rates low, the temptation to pay only the interest portion of the loan each month is great. However, keep in mind that the HELOC interest rates can rise quickly if the Fed decides to raise rates one or more times over a short period of time.

Plus, we’ve had a frothy real estate market before. Last time we were in the situation, hundreds of thousands of consumers began tapping into their home equity to remodel kitchens and baths, take vacations, buy investment property or second homes, and even pay for college tuition.

Many even used their equity loans or lines of credit to pay down high interest credit cards. That was a good strategy, so long as they didn’t run up their credit cards again. Those who did suddenly found themselves with more credit card debt and home equity loans to pay off.

Eventually the housing market collapsed and with it the job market. When that happened, home equity loans and lines of credit still had to be repaid … and many people lost their homes because they could not make their payments.

With all this in mind, the best strategy is for consumers to pay down the principal while their interest rate is still low. As the principal amount drops, so will the interest paid on the line of credit. Even if the Fed raises rates, you can lower your monthly payment by paying the principal down quickly.

All in all, if you manage the HELOC wisely, it is a convenient, low-cost way to borrow money. With that in mind, homeowners could easily be winners in this environment.

Of course, if you don’t, it could become a costly burden during a higher interest rate environment. Hence, homeowners could also easily lose out if they aren’t smart.

One major difference between 2006 and 2013, though, is that most Americans do not have as much equity in their homes today as they did seven years ago. Plus, the rates for both debt levels and debt delinquencies have fallen quite a bit since 2006 and if consumers have learned their lesson, it’s possible that they may not look to the banks to bail them out with equity loans and lines again.

In addition, most banks have tightened the equity requirements of their lines of credit, and will only lend you 60% or 70% of the value of your home.

Say for example, you want a HELOC on a home that is currently worth $250,000, and you owe $200,000 on it. Even if a bank is willing to lend you 70% of the value, that would only be $175,000. Since you owe more than that amount, you would not qualify for the HELOC.

However, if you only owed $100,000 on that same home, you could set up a line of credit for the difference between the $175,000 and the $100,000 owed, or $75,000 total.

One thing for certain is that the big-box stores such as Home Depot (HD[2]), Lowe’s (LOW[3]) and Walmart (WMT[4]) who sell household goods and improvement services will certainly benefit from any increase in home equity loans and lines. So will banks that perform these equity loans, such as Regions Financial (RF[5]).

It’s even been suggested that banks are purposely keeping inventory levels down by dragging their feet on foreclosures to prop up real estate prices. The banks know that as equity rises, so will the number of HELOC and home equity loans that they can write. So in essence, by holding their foreclosures longer, they lose nothing in the long-term.

Thus, the best strategy for homeowners is to keep their debts low, and if they must use their home equity for improvements or other expenses, to pay down the principal as quickly as possible, thereby keeping their interest levels down and paying off their loans while we still have a low interest rate environment.

As of this writing, Ethan Roberts did not own a position in any of the aforementioned securities.

Endnotes:
  1. 10.9% year-over-year increase in nationwide home prices.: http://investorplace.com/2013/05/the-housing-boom-continues-but-which-homebuilders-to-buy/
  2. HD: http://studio-5.financialcontent.com/investplace/quote?Symbol=HD
  3. LOW: http://studio-5.financialcontent.com/investplace/quote?Symbol=LOW
  4. WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT
  5. RF: http://studio-5.financialcontent.com/investplace/quote?Symbol=RF

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