Home equity loans and lines of credit are once again being pushed by banks hungry for profitable business, according to a recent Wall Street Journal article. Here we go again. It's as if the lessons learned from the housing crisis have been wiped away.
The WSJ article noted that in 2015 lenders extended $156 billion in home-equity lines of credit -- the largest dollar amount since the housing bust started in 2007. And the average line amount was a record $119,790.
A home equity loan is money you take out immediately, while a home equity line of credit (HELOC) is an opportunity to take cash out at some time in the near future. A HELOC is a sort of pre-approval, much like the limit on your credit card. It's tempting to use it immediately.
But before you jump at the enticing prospect of taking some extra cash out of your home now that prices have rebounded, you might want to consider all the ways you could get burned by turning your house into a piggy bank.
1. Beware tempting low rates. These lines of credits offer tempting low interest rates - but if the overall level of interest rates rises, you could be exposed to much higher payments. Unlike a fixed rate mortgage you could lock in now at less than 4 percent, these loans carry variable rates.
2. Understand the terms. Most of these lines of credit offer tempting low monthly payments because you are not repaying principal each month, only interest. Then at the end of a set period - typically 10 years - you have a "balloon" payment of the entire principal! You have no idea what interest rates or credit conditions will be then - or whether you will be able to qualify for a second mortgage or refinance this balloon into your outstanding mortgage.
3. Consider your credit. It takes reasonably good credit to qualify for a home equity loan. The WSJ article notes that the average weighted FICO score for home equity line borrowers recently was 781 (on a scale from 300 to 850). But left unsaid is the impact of having an outstanding borrowing on a HELOC. The minute you start drawing down that line, your borrowing ratio soars - lowering your score, and perhaps making it difficult or more expensive to buy that new car or even to get life insurance!
4. Consider your risks. Lenders are likely to demand that you have at least 20 percent equity in your home after the borrowing. So they know they have a good chance of getting their money back if you default. And they know that because you have that equity, you'll do everything possible to avoid a default and foreclosure. To the lenders, home equity loans are a practical business decision, spreading the risk of an individual default over many homeowners. For you, it's a very personal risk.
5. Study the alternatives. We had a graphic demonstration in the past decade of how losing your home disrupts your life - present and future. Fond memories of a family vacation fade quickly when a "For Sale" sign hits the front lawn. Even tuition doesn't look like a good investment when the kids who can't get jobs can't come back to their old bedroom to hide.
When it comes to home equity loans and lines of credit, Shakespeare had it right: "Neither a borrower, nor a lender be." Banks are setting themselves up for another round of losses down the road if these loans come due in an economic recession. And homeowners are setting themselves up - once again - for a risky situation that puts their home on the line at repayment time.
Your home is not a piggy bank. And that's The Savage Truth.