In the mid-2000s, prior to the housing crisis, a home equity line of credit (HELOC) was a popular choice for homeowners with soaring home values and the need for extra cash. That choice is beginning to have unfortunate consequences for homeowners who acquired their HELOC at the peak of the housing boom.
HELOCs have great appeal because of their unique structure. During the drawdown period (typically the first ten years), borrowers generally only make interest payments. As a further incentive, the monthly payments on a HELOC are tax deductible.
After the drawdown period, the loan "resets" as principal payments on the loan kick in (typical repayment terms are fifteen years). Monthly payments rise sharply at the beginning of the reset, but drop over time as the interest is paid off.
An example provided by the mortgage data firm HSH illustrates the magnitude of the problem. Given a $100,000 HELOC balance at 4.5% and a twenty-year repayment phase, the payment would rise from $375 during the interest-only period to $633.
Given a variable interest rate, the pain of a HELOC reset can be intensified by significantly higher rates — especially when you have become used to your drawdown payment and forgotten about the reset. Rates may still be low, but they are not likely to stay that way during the repayment period.
Resets are beginning to come due for borrowers that took out HELOCs during the housing bubble — approximately 840,000 HELOCs this year and another 1 million in 2017, according to The Wall Street Journal — and the effect is showing. HELOCs that reset earlier this year are showing a significant increase in delinquencies covering $2.8 billion in balances.
During the housing boom, homeowners ignored concerns about the repayment period, assuming that with continued growth in housing prices that they would easily be able to refinance and effectively start over with a new drawdown period. The subsequent crash not only dashed those plans, it left many homeowners owing more than their home is worth ("underwater"). A substantial number of those homeowners are still underwater, and the added burden of higher HELOC repayments may be enough to force some of them into foreclosure.
What can you do if you have a looming HELOC reset in your near future? You can ease the burden by making extra payments on the principal before the reset, to the extent you can afford to do so. Beyond that, your best hope is to refinance — if you have suitable credit.
To refinance, you will need a good credit score (potentially in the 700 range), a low debt-to-income ratio, and a solid source of income — just as you would for most home purchases. Depending on your qualifications and preferences, you may simply be able to take out a new HELOC that includes the old balance or refinance the combined HELOC and outstanding mortgage. At current low rates, a combined refinance is probably the better option to avoid the longer-term pain of yet another reset at rates that are likely to be considerably higher.
If you are underwater in your home or have insufficient credit to refinance, your options are limited. The best choice is to try to work out extended terms for your HELOC repayment. You will pay more over time but can reduce your monthly payments to a more manageable level. The HELOC holder has incentive to work with you, since a HELOC is essentially a second mortgage on a home and is therefore less likely to be repaid should you fall into foreclosure.
HELOCs are useful borrowing tools if used correctly, but they can lead to dangerous debt spirals if care is not taken. If you are considering taking out a new HELOC, make sure that you learn from those who are currently experiencing the pain of reset, and make sure you can afford the repayment phase without assuming a favorable refinance in the future.