A home-equity line of credit (HELOC) once seemed the perfect solution for homeowners who needed cash. The economy was booming, house prices were at record levels and getting a mortgage never seemed easier. In those heady times of rising home values, drawing money on your home’s equity seemed like a pretty good bet.
Most bets are off these days, however. Many banks are rolling back on the HELOC promise. According to an April survey by the Federal Reserve, about 70 percent of financial institutions reported they have tightened credit standards for new applications for revolving HELOCs, and half have reduced existing lines of credit. Just last week, Morgan Stanley, the nation’s second largest U.S. securities firm, notified thousands of clients that they would no longer be allowed to draw money from their HELOCs.
Why the sudden stiffening of HELOCs? It’s the economy, banks say.
“Banks are in the business of lending, says James Chessen, chief economist for the American Bankers Association. “They have to weigh the likelihood that they are going to be repaid. The weaker the economy, the greater the risk.”
Meanwhile, some economists point to consumers.
“Basically, we spent much of the last decade with consumers aggressively using HELOCs with rapid balance growth,” says Scott Hoyt, an economist with Moody’s Economy.com.
That, economists say, is part of the problem. Too many homeowners using their homes as ATMs means that even while homeownership has climbed to record heights, home equity has fallen below 50 percent, according to the Federal Reserve.
“Homeowners have less equity to borrow against,” Mr. Hoyt says.
The decline in home values has left some homeowners with HELOCs actually owing more than they own.
Late payments on home-equity lines of credit rose to an 11-year high in the first quarter of 2008, according to the American Bankers Association. Meanwhile, Moody’s Economy.com reports that delinquencies on HELOCs were up 47 percent in the last year, although they remain the lowest category of consumer credit delinquencies.
During the boom times, many lenders relaxed the old standard of extending credit only to those who had at least 20 percent equity in their homes. Today’s shrinking home values mean lenders are returning to a more traditional calculus.
“Bankers are asking more questions of borrowers,” Mr. Chessen says. “They want confirmation of sources of income, length of employment and other debt. They want to know what the total debt burden is going to be.”
If you live in an area where home prices have fallen 10 percent or more, it’s fairly likely you may be in for a HELOC freeze.
“The more rapidly house prices are falling, the greater the possibility that lenders will freeze a HELOC,” Mr. Hoyt says.
Other factors that could affect your HELOC in these tougher times are missed payments, changes in credit scores, or if you purchased your home in the last few years with little money down. At the same time, a frozen HELOC could affect your credit rating because many credit bureaus interpret that to mean you have borrowed the maximum amount available to you.
Before you start looking for another source of income, consider this: Many lenders still offer HELOCs, although regulations have tightened, and for those consumers who are still able to tap into their home’s equity through a line of credit, satisfaction has never been higher, according to a customer survey released in May by J.D. Power and Associates.
“With all the negative press around, people who did obtain loans were more satisfied,” says Tim Ryan, senior research director of the finance and insurance practice at J.D. Power and Associates.
So what exactly is a HELOC? Generally speaking, a HELOC is a form of revolving credit like a credit card (one with a very high credit limit, since it is secured by your home). You withdraw what you need as you go. Whenever you withdraw money, interest accrues.
Individual HELOCs can vary. Some may differ about the manner of repayment, others about how to determine your credit line. Rates and rate caps can differ from bank to bank. Bankrate.com offers information about HELOC rates and bank standards, allowing you to comparison shop and see how much credit you can receive.
“Costs vary, and rates are in a state of flux,” says David Bradley, a spokesman for Bank of America, the highest-rated lender in the J.D. Power and Associates survey. “Astute buyers should be able to find a good deal.”
A credit line usually is determined by taking a percentage of the home’s appraised value and subtracting from that the balance owed on the existing mortgage. The answer also is dependent upon a number of factors, including your income, debts and other financial constraints. Lenders will scrutinize your credit history to determine your ability to repay the loan, especially in today’s shrinking economy.
These days, many banks have reduced the percentage of the home’s value that is used to establish a HELOC. That means your loan-to-value cap can be much lower than when you originally established your HELOC.
Most HELOC recipients use their lines of credit for big-ticket items such as medical expenses or college tuition. Increasingly, though, homeowners are tapping into home equity to improve their homes and relieve their debt, Mr. Ryan says.
“We’ve seen use of credit lines and loans used for consolidation of bills or home improvement.”
Many of the costs associated with establishing a HELOC are similar to those incurred when purchasing a home. They include property appraisal fees, application fees, points and closing costs. There also may be annual membership and maintenance fees and a transaction fee when you draw from your line of credit. You may also be required to withdraw a minimum amount each time or maintain an outstanding balance.
HELOCs often seem attractive because they carry lower annual percentage rates than other types of loans or lines of credit. The interest may be tax-deductible because it is secured by your home. Default on your HELOC, though, and you are in danger of losing your home.
HELOCs generally carry a variable rate that may change over time. The variable rate must be based on a publicly available index (such as the prime rate published in some major daily newspapers or a Treasury bill rate). Most lenders cite the interest rate you will pay as the value of the index at a particular time plus a “margin,” such as 2 percentage points. Because the cost of borrowing is tied directly to the value of the index, it is important to find out which index is used, how often the value of the index changes, and how high it has risen in the past as well as the amount of the margin. Even small changes in the index can increase payments significantly.
These days, lenders are looking for applicants with low debt-to-income ratios, solid employment histories and other indicators of financial stability.
“We don’t want them to get into a situation where they are hard-pressed,” Mr. Bradley says. “We want to be sure customers are in a position to repay.”
Not everyone is a good candidate for a HELOC. Carefully weigh the benefits - and costs - of a HELOC before making your decision.