This is a carousel. Use Next and Previous buttons to navigate
As the Federal Reserve announces a rate change, traders work the floor at the New York Stock Exchange. Banks raised their prime rate to 4.75% Thursday after the Fed raised the funds rate by three-quarters of a percentage point.
Home equity lines of credit are enjoying a resurgence among Bay Area homeowners.
When Sean and Kate Sitter needed money last year to update their home in San Jose, they took out a new loan for more than the balance on their existing loan, paid off the old loan and used the extra money for home improvements. This is known as a cash-out refinance.
Since then, mortgage rates have shot up by about three percentage points. So when the couple needed more money this year to do more renovations on their home and a second one in Carmel, there was no way they were going to touch that mortgage, which is fixed at 2.875% for 30 years. Instead, they did what more homeowners wanting to borrow against their home equity have been doing: They got a variable-rate home equity line of credit, which is one type of second mortgage secured by equity in a home.
Commonly known as HELOCs, they let you borrow up to a certain dollar amount, but rather than taking it all in a lump sum, you can borrow just what you need and make payments only on your outstanding balance.
With mortgage rates nearing 6%, “if you have a fixed- rate mortgage down around 3% or even 3.5%, to do a cash-out refi today means exposing all of your mortgage, plus what you want to borrow on top of that, to a much higher interest rate,” said Keith Gumbinger, a vice president with mortgage tracker HSH Associates. That’s why HELOCs are enjoying a resurgence.
Redwood Credit Union in Santa Rosa has seen a 16% increase in HELOC balances since January.
In the first five months of this year, 107,238 people were approved for HELOCs and home equity loans (a second type of second mortgage) on LendingTree.com, an online loan marketplace. That compares with only 83,841 offered in the first six months of last year.
HELOCs were wildly popular leading up to the 2008 financial crisis, and played a role in it, but fell out of favor afterward. As home prices fell and mortgage delinquencies rose, many homeowners had their lines of credit frozen or canceled. As interest rates fell, homeowners with equity to borrow against were more likely to do cash-out refis, because they could lower their rate and get money at the same time. In 2017, Congress took away some of the federal tax breaks that had made home-equity debt so appealing.
During the first few months of the coronavirus pandemic, some major banks, including Chase, Wells Fargo and Citibank, stopped making new HELOCs altogether.
Today, with mortgage rates rising at their fastest pace in 38 years, refinancing activity has fallen off a cliff. Thanks to soaring prices, many homeowners still have gobs of equity, and “the pendulum has swung back in favor of HELOCs, said Jeff Ostrowski, a mortgage writer with Bankrate.com.
These loans, however, come in more flavors than ever before, which makes comparison shopping more complex, and more important.
Rates and terms vary widely from person to person and lender to lender. “Don’t assume your current lender will give you the best possible rate” on a HELOC, said Jacob Channel, senior economic analyst at LendingTree.
Some borrowers wanting to tap their equity might prefer fixed-rate home equity loans, which are more straightforward.
Home equity loans and lines of credit are called second mortgages because they usually sit behind a first mortgage. In a foreclosure, the holder of a second mortgage won’t get a dime until the holder of the first mortgage is paid in full.
Most home-equity lenders will let you borrow, on a first and second mortgage combined, up to 80% or 85% of your home’s market value. If your home is worth $1 million and the balance on your first mortgage is $600,000, you might be able to borrow up to $200,000 or $250,000 on a home equity loan or line of credit.
These two second mortgages differ in important ways:
A home equity loan is a closed-end installment loan, typically with a fixed rate. You borrow a lump sum and make fixed principal and interest payments, as you would with a first mortgage, over the term of the loan — typically five to 20 years. You’ll pay a bit more on a second mortgage than you would on a new first because the second is riskier to the lender.
None of the megabanks — Chase, BofA, Wells Fargo or Citibank — offer closed-end home equity loans, having ceded the field to smaller banks and credit unions.
A HELOC is an open-end revolving loan. Typically, there is a 10-year draw period, during which you borrow only what you want, pay some or all of it back, then borrow more, as long as you stay under your credit limit. In this respect it’s like a credit card. During the draw period, you make payments on your outstanding balance.
Most lenders allow interest-only payments during the draw period. Some, including Bank of America, require principal and interest payments.
Others, such as Fremont Bank, let borrowers choose between one HELOC that requires interest-only payments and another HELOC that requires principal and interest during the draw period.
After the 10-year draw period, you enter the repayment period. At this point, you can’t borrow any more money and must begin making monthly principal and interest payments on your balance. The repayment period typically lasts 15 to 20 years.
Historically, HELOC rates were variable throughout the term of the loan, during the draw and repayment periods, and most still are.
Almost all HELOCs are tied to the prime rate, which is usually three percentage points higher than the federal funds rate. When the Federal Reserve raises or lowers the funds rate, the prime rate follows the next day and banks adjust their customers’ HELOC rates the next month. Banks raised their prime rate to 4.75% on Thursday after the Fed raised the funds rate by ¾ of a percentage point on Wednesday.
Most borrowers pay a fixed percentage, called a margin, over the prime rate. If your margin is 1% and prime is 4.75%, your new rate will be 5.75%. Most HELOCs have a lifetime cap around 18%.
Your margin over prime will depend on your home type (single- or multi-family, primary or secondary residence or investment property) and its location; your loan-to-value ratio, credit score, debt-to-income ratio and credit limit; and, of course, the lender.
Many lenders offer a discounted or “teaser” rate that is fixed during the first one to 12 months. Some offer additional discounts if you sign up for automatic payments, link your HELOC to a checking account at the same institution or draw down a certain amount at the outset.
Thanks to their solid credit scores and low loan-to-value ratio (about 45%), the Sitters got a HELOC from Keypoint Credit Union that is fixed at 3.25% for one year, “then it goes to prime plus zero” with a 4% floor, Sean Sitter said.
In recent years, some lenders have started offering HELOCs that have a fixed-rate component.
One way they do this is by fixing the rate for an “extended introductory period” of one to five years, said Todd Dal Porto, Fremont Bank’s group executive for residential lending.
Another way they do it is by letting you fix the rate on all, a portion or several different portions of your balance during the draw period. “It’s a loan within a line,” Gumbinger said.
BofA lets borrowers fix the rate on up to three portions of their HELOC balance (minimum $5,000 for each). For the same customer, the fixed rate might be 0.25 to 0.5 percentage points higher than the customer’s then-current variable rate. But if the variable rate falls below the fixed rate, customers can switch back to a variable rate, said David Gorman, BofA’s retail lending executive for Northern California. BofA does not charge a fee to fix or unfix the rate.
Many lenders absorb the one-time closing costs on HELOCs and sometimes on home equity loans. Many charge an annual fee on HELOCs, typically around $100, often waived for the first year. Some charge a fee if you prepay a home equity loan or close a HELOC within the first few years.
Lenders can typically freeze or lower a customer’s HELOC credit limit or close an unused line of credit if the borrower becomes delinquent, home values tumble or under other “adverse conditions,” so read the fine print. That’s not a risk with home equity loans.
Borrowers still have to provide proof of insurance, income and assets to get a second mortgage, although some documentation requirements are less onerous for HELOCs than first mortgages, “particularly if you are obtaining it from your existing lender. We still make sure the client has the ability to repay,” Dal Porto said.
Before tapping your equity, make sure it’s the right choice. If you default on a first or second mortgage, you could lose your home. That’s not true with credit cards and personal loans, which generally have higher rates.
Next, find a lender who can thoroughly explain the pros, cons and fine details of various home equity products. Many lenders don’t sell second mortgages through brokers and other third parties, like they often do with first mortgages.
If you need a fixed amount up front — perhaps to consolidate other debts — and want to pay it off over the long-term, a home equity loan may be right, especially if you’re not comfortable with fluctuating interest rates and payments. If interest rates come down, you could refinance the loan, assuming you have sufficient income and equity and can find a lender who will do it.
If you’re not sure how much you need or don’t need it all at once — perhaps for a big remodeling project or college tuition — a HELOC might be the answer.
Some people take out HELOCs as an emergency fund. Brett Nicoletti, a mortgage broker with Academy Mortgage in Los Gatos, recently got a HELOC from a credit union because “I wanted to have it for a rainy day. I’m in a cyclical business. This year is probably going to be fine but moving into 2023-24, I might need cash.”
He added, “If things start getting kind of sketchy and recessionary clouds are forming, the playing field for those loans will change. Qualifying will be harder, they will probably be smaller and margins over prime might go up.”
Although they’ve become much less popular and the closing costs can be high, some people are still doing cash-out refis. “If you have a very small first at 3%, but you want to borrow $500,000 or $1 million, in that case a cash-out refi might make sense,” Dal Porto said.
Be aware: The interest rates you see advertised are usually the lowest rates for a lender’s best customers. Make sure to compare the rate you personally would pay. But don’t let rates outweigh other considerations.
Michelle Anderson, Redwood Credit Union’s chief lending officer, was helping a couple considering three options. “It was all premised on when they wanted to retire. The interest rate was not a question; it was all about cash flow and when do they want to pay it off,” she said.
Kathleen Pender is a freelance writer and former columnist for The San Francisco Chronicle. Twitter: @KathPender
More: Can you deduct interest on a second mortgage in California?
Kathleen Pender was a San Francisco Chronicle journalist for 36 years. After serving as a business reporter and editor, she wrote the Net Worth column from 2000 to 2021, where she explained how the big business and economic news of the day affected a household’s net worth. She majored in business journalism at the University of Missouri-Columbia and was a Knight-Bagehot fellow in business journalism at Columbia University.
This is a carousel. Use Next and Previous buttons to navigate