August 20, 2015

“Recently you pointed out a slew of problems now faced by borrowers who took out HELOCs before the financial crisis. Their timing was terrible, but that’s water over the dam. Are conditions more favorable to borrowers taking out HELOCs now?”

In some respects, conditions are more favorable now for HELOC borrowers who meet the standards, which are tougher than they were before the crisis. Lenders now generally want borrowers to have equity of 20% after drawing the maximum amount under the line. That means that if a house is worth $200,000 and the first mortgage balance is $140,000, the HELOC line cannot exceed $20,000, which would result in total mortgage debt equal to 80% of value. Before the crisis, many HELOCs were written with no or negative equity, reflecting a widespread belief that house prices always rise. The higher equity requirements today are designed to protect the lender, but they also prevent borrowers from getting in over their heads.

Another feature of the current market that is more favorable than the pre-crisis market is that the decline in house values that caused the crisis, creating problems for all kinds of mortgage borrowers,   will not be repeated any time soon. Barring a world-wide epidemic of amnesia, the substantial house price decline during 2006-2010 was a once-in-a-century phenomenon. The one before that, which was both deeper and longer, occurred during 1929-1936.

Is the Pricing of HELOCs Especially Advantageous to Borrowers?

“If I understand correctly from my bank, first mortgages are calculated using compound interest. HELOC’s are calculated using simple interest…therefore a HELOC payment goes primarily to principal whereas the payment on a standard mortgage goes primarily to interest…if my facts are correct, does that not mean that it is wise to have as much on a HELOC as possible and minimize the amount on the standard mortgage?”

The inference you drew from your banker’s comments are flat-out wrong. It is true that standard mortgages charge compound interest and HELOCs charge simple interest, but what that comes down to is a difference between a monthly interest calculation and a daily calculation. For example, if the loan balance in both cases is $100,000 and the interest rate is 5%, on a standard mortgage you owe .05x100,000/12 = $416.66 for the month, regardless of the number of days in the month. On a HELOC you owe .05x100,000/365 = $13.70 a day, which is $411 for a 30-day month and $425 for a 31-day month.

This difference has no implications for the allocation of payments between principal and interest. In both cases, interest is calculated as described above, and the part of the payment above the interest charge automatically goes to principal. Which is better for the borrower, all other things the same, depends on the circumstances and practices of the borrower. Daily pricing can be a trap for borrowers who procrastinate in making payments, and useful to borrowers managing volatile cash flows, who value its flexibility.

Under What Circumstances Would the Mortgage Professor Take Out a HELOC Today?

I wouldn’t use a HELOC for any purpose that required that I draw the full amount of the line at the outset. This includes using it as a semi-permanent source of funding for purposes such as purchasing a house or paying for education.

Drawing it all would whack my credit score, because HELOCs are a form of revolving credit and the utilization rate on revolving credit lines is considered a measure of creditworthiness. Drawing the full line would also expose me to serious interest rate risk. That risk is much greater for HELOCs than for standard adjustable rate mortgages. While the prime rate to which HELOC rates are tied has been at 3.25% since December 2008, don’t be fooled by that. In 1980, the prime rate changed 38 times and hit 21.50%. There are no rate adjustment caps on HELOCs as there are on ARMs, and maximum rates are generally 18% as compared to 10% or so on most ARMs.

HELOCs have two valuable features: flexibility and low upfront costs. Good uses of HELOCs are those that take advantage of those features. Borrowers with highly fluctuating incomes combined with fixed payment obligations can use a HELOC to help manage their cash flows. This type of use involves drawing on the line when necessary, and repaying it when possible.

A HELOC can also be used to finance a project, such as major renovations to a house, that will involve irregular outlays over a future period of unknown length. The problem with this type of use is that the HELOC balance may grow to the point where the borrower’s exposure to a rise in interest rates becomes  excessive. That can be avoided by converting the HELOC at some point into a home equity loan, which will be for a fixed amount and carry a required monthly payment.