With experts forecasting that unemployment rates may hit 30% as the coronavirus moves across the U.S., the number of people wondering how they’re going to pay their bills is probably at least that high or higher. Fortunately, nearly two thirds of American households own the homes they live in, according to the Census Bureau.
The equity in those homes represents a rich source of potential financial assistance in time of need. About 45 million American homeowners have about $6.3 trillion in available equity, according to mortgage data collector Black Knight. That comes to about $140,000 per borrower—a tidy sum to help pay bills during the COVID-19 crisis.
There are several ways homeowners can turn the equity in their homes into ready cash to replace job income lost due to pandemic-related shutdowns. One option for leveraging the value of a home is the home equity line of credit, or HELOC.
What Is a HELOC?
A HELOC is a revolving line of credit—think of it like a credit card—that lets you borrow as much as you need, when you need it, up to the limit of the line of credit. You can draw on this line of credit by writing checks or using a credit card connected to the account.
What makes a HELOC helpful in uncertain times like these is the flexibility it offers. Once you have the line of credit set up, you can draw down a lot or a little, as needed. And you only make payments on the amount you have actually borrowed, not the total amount of credit available.
You also may get some tax advantages, and interest rates are lower than for many types of loans. Under normal circumstances, HELOCs are easy to qualify for, even if you have less-than-spotless credit.
However, HELOCs aren’t perfect. They come with their own risks and limitations—the biggest of which right now is the financial uncertainty surrounding both consumers and mortgage lenders. It’s worth noting that encouraging banks to make more home equity loans is one of the ideas being floated as a potential partial solution to the financial realities of widespread unemployment.
How HELOCs Work
HELOCs are similar to home equity loans because they use the equity in your home as security against a loan. They’re different, in that a home equity loan is for a lump sum. A HELOC is more flexible because it’s there if you need it and you only make payments on the amount of the available credit you actually use.
Both home equity loans and HELOCs have a significant limitation: You typically can’t borrow more than 85% of the value of the equity in your home, also known as the loan-to-value ratio, or LTV. That’s a maximum. Some borrowers may allow this loan-to-value figure to be as low as 65%.
If you decide to look into a HELOC, comparison shopping is essential. Lenders vary widely in the interest rates, fees and terms of the HELOCs they offer. Banks, savings and loans, credit unions and mortgage companies all offer home equity loans. Mortgage brokers don’t make loans but can help arrange them.
Talk to at least three potential sources of a HELOC. Carefully compare interest rates and fees such as loan origination charges. Note that, unlike quotes for home equity loans, which include an annual percentage rate (APR) that factors in financing charges and discount points, the APR on a HELOC does not include points and other charges. A HELOC APR is the same as the interest rate.
Interest rates on HELOCs are usually variable. These may change over the life of the credit line. This means your payments also may change, even if you don’t borrow more money. The HELOC will likely have a periodic cap that limits how much the interest rate can change at one time. It also may have a lifetime cap, limiting how much the rate can vary over the life of the loan. Pay attention to these details.
Also look at the index the rate will be based on. This is often the prime rate. (The prime rate closely tracks with the Federal Reserve’s federal funds rate, which is currently close to 0%.) The lender won’t charge you the prime rate itself but will add a margin to the published figure. Ask about this margin as well.
Sometimes you can convert the HELOC to a fixed interest rate later on. This can be an advantage. But watch out for temporarily discounted introductory rates, which are low in the early days of the loan but can rise sharply later on.
As with any home loan, fees can be significant. You’ll pay an origination fee, an application fee, points, appraisal, title search and other fees. The good news is that these fees are negotiable. If one lender has a lower charge for a major fee like the origination fee, let the others know and see if they’ll match it.
Unlike other home loans, HELOCs may come with ongoing fees. These may be tagged as participation or membership fees or come in the form of transaction fees when you tap your line of credit. These can add up over time and significantly increase the loan cost. Other fees to check for include penalties for late payments.
Your HELOC may have a minimum withdrawal amount. There may be a maximum withdrawal amount as well. Often there is a draw period, which is the only time during which you can actually make withdrawals. After the draw period ends, you can no longer access the line of credit, so make careful note of this date.
Typically, you can either write checks to get cash, or use a credit card, or both. See that you are comfortable with whatever your loan specifies because you can’t change this later.
Qualifying for a HELOC is easier than qualifying for most loans. If you have sufficient equity, your chances of being approved are good. Your credit score, which is often a major factor in qualifying for other loans, is not as important with a HELOC, where your property is providing security for the lender.
If you sign the paperwork for a HELOC and then change your mind, you have three days to back out. By federal law, you have until midnight of the third day after you sign the paperwork to cancel. You have to tell the lender in writing, not by phone or orally.
The benefits of the HELOC include a lower interest rate than with most other loans. Rates are variable and will be higher than the 3.50% average Freddie Mac reported on March 26, 2020 for 30-year fixed rate mortgages. But HELOCs will still have significantly lower interest rates than personal loans or credit cards.
Another advantage is that the potential available credit the HELOC represents is already present in an asset you control.
The flexibility of a HELOC, as noted, is a major plus. You only borrow what you need. And they’re reasonably easy to qualify for.
A HELOC is not meant to be used as an ATM. The big risk with a HELOC is that you could lose your home if you don’t pay it back. Some HELOCs come with a balloon payment at the end. If you can’t make this payment, and can’t refinance the loan, you could face foreclosure.
The variable interest rates mean that you can’t say for sure what your future payment will be. And, if you sell the house, in most cases, you will have to pay off the HELOC’s balance at the time of sale.
Another risk is that if the value of your home declines in a down market, the lender may freeze the account so that you can’t make any more withdrawals. This happened to many HELOC borrowers during the last housing crisis.
A potentially significant negative is that it may be hard to get a HELOC right now. The unsettled financial situation has some lenders reluctant to fund new HELOCs. If your employment situation is uncertain, you might benefit from offering to have a co-signer for the loan, if one is available.
A HELOC isn’t the only—and perhaps not the best—way you may be able to bolster your finances for the short term. For instance, getting a lump sum of cash with a home equity loan instead means you can put that money in the bank rather than taking a chance that your home value will fall in the future and a HELOC lender will stop further draws. A cash-out refinance is another option. More lenders may offer these than are offering HELOCs.
A personal loan, while charging a higher interest rate, doesn’t have nearly as much in the way of closing costs and other fees. Credit cards sport still-higher rates, but can be tapped instantly rather than waiting up to several weeks for a closing and the activation of a HELOC account. You can perhaps use one of these financial stopgaps short-term and, if the crisis takes a longer time to resolve, then use a HELOC to pay off the higher-cost loans later on.
Finally, several forms of government-organized help are on the way, courtesy of the Families First Coronavirus Response Act and the $2 trillion stimulus package. Government-backed mortgage companies Fannie Mae and Freddie Mac have already introduced forbearance programs to reduce or suspend mortgage payments for up to a year, in response to financial hardship caused by the coronavirus.
The U.S. government is also encouraging—and, in some cases, requiring—private businesses such as telecommunications firms, utilities and even landlords to step up to help consumers deal with the potentially long-term disruption to their livelihoods. Businesses and government entities alike are offering deferred payments, waiving penalty and late fees, and suspending foreclosure sales and evictions.
HELOCs have gotten less popular in the decade since the Great Recession and, depending on your situation, you may find another way of dealing with the current financial uncertainty that makes more sense. However, there is plenty of leverage, in the form of home equity, available to a homeowner. Now might be the right time for many homeowners to consider tapping this deep pool of wealth to help their families get through the most unsettled financial times in recent memory.