What happens to HELOCs if home values fall?

2022 was a rocky year in real estate. In the spring, home values in many markets reached all-time highs. And then they went into retreat for the rest of the year. The triple whammy of high inflation, low inventory and a steep rise in mortgage rates began to dampen demand, as prospective buyers faced serious affordability concerns. In early 2023, for the first time in more than a decade, home prices are falling or seriously stagnating. Values in some once-hot markets have already dropped nearly 10 percent from their 2022 peaks.

For borrowers with home equity lines of credit (HELOCs), the new reality of the housing market creates uncertainty. Some homeowners might remember the fallout from the Great Recession, when banks froze previously approved lines of credit. Now, with economists predicting a 65 percent chance of recession in the next 12 to 18 months, what does that mean for HELOCs this time around?

Key takeaways

• Who: Homeowners with home equity lines of credit (HELOCs)
• What: If house values decline, lenders might limit homeowners’ access to their HELOC
• Where: Across the U.S.
• Why care: Homeowners with HELOCs may need to adjust plans to tap their equity for cash for home improvements, debt repayments or other expenses

How HELOCs work

A HELOC is a revolving form of credit with a variable interest rate. When you’re approved for a HELOC, your lender sets a credit limit based on your available home equity. Typically, you can borrow up to 85 percent or 90 percent of your home’s value, minus outstanding mortgage balances.

You can calculate your maximum HELOC borrowing amount with this equation:

Say your house is worth $400,000 and your bank allows you to tap 90 percent of your equity. That means you could run your total debt on the property up to $360,000. If you still owe $200,000 on your mortgage, you could have a credit line of $160,000 with a HELOC:

($400,000 x 0.9) - $200,000 = $160,000

Say your home’s value falls 5 percent, to $380,000, and you still owe $200,000 on your mortgage. You now have less tappable equity. Instead of having a maximum HELOC balance of $160,000, your total draw would be $142,000.

($380,000 x 0.9) - $200,000 = $142,000

Of course, you don’t have to take the entire amount at once. Often, borrowers use a HELOC as they do a credit card: They tap some of their credit line and then pay it back, without maxing it out. The point is, a drop in home value means a drop in the available amount you could withdraw.

How would a housing market crash impact my HELOC?

Until last year, home values across the U.S. had been steadily increasing. But in 2022, when mortgage rates doubled from the year before and house price tags were rising faster than salaries, sales and property values finally began to cool.

Economists expect 2023 to be another uncertain year in real estate, with dampened demand and limited housing inventory. Most experts also agree that a housing market crash isn’t likely and anticipate any retrenchment by HELOC lenders to be mild. However, if you have a HELOC and the value of your home tumbles, don’t be surprised if your lender reduces the amount of home equity you can borrow against.

Say you borrowed the whole amount of your HELOC at once to pay for a major renovation. In that case, you can expect no change to your loan amount or payments. “If you’ve already drawn the HELOC, you’ll just keep paying as agreed,” says Ellen Steinfeld, executive vice president and head of Consumer Lending and Payments for Berkshire Bank in Boston.

On the other hand, if you haven’t tapped the full amount of your HELOC and home values in your area start dropping, lenders might begin adjusting the amount of your equity based on your place’s new worth. That’ll affect your credit limit.

Some lenders may decide to cap the amount of the HELOC you can use.

— Ellen Steinfeldexecutive vice president, Berkshire Bank

Steinfeld is quick to point out, however, that her bank has not taken such steps, and she has yet to see a decline in New England home values. If the housing market there does take a turn, “we would be educating borrowers that we could cap the line.”

To be sure, Steinfeld doesn’t expect a repeat of the HELOC chaos that accompanied the global financial crisis of 2008. During that period of financial collapse, lenders froze and even called HELOCs, a move that took borrowers by surprise. “One of the problems during the Great Recession was a lack of communication,” says Steinfeld.

Advantages of HELOCs

HELOCs have grown more popular in recent months for a simple fact: The sharp run-up in mortgage rates in 2022 means another common way of tapping equity, the cash-out refinance (a newer, bigger mortgage) is no longer appealing. Why would a homeowner opt for an interest rate around 6–7 percent (for the refinance) vs up a 3 percent interest rate (for the HELOC)?

Oher advantages of HELOCs include:

• They have slightly lower upfront costs and interest rates than home equity loans and lower APRs than credit cards.
• You can borrow more money as you need it rather than receiving a lump sum (like you would with a home equity loan).
• If you’re using your HELOC for home renovations or repairs, the interest may be tax-deductible.
• Repayment options can be more flexible than other lines of credit, with many lenders allowing interest-only payments during the draw period (usually the first 5-10 years of the loan).

Disadvantages of HELOC loans

However, even the best HELOC rates have a few downsides, as well. Some of the biggest disadvantages include:

• Rates are typically variable, so they can rise.
• Like home equity loans, HELOCs require you to use your house as collateral, putting it at risk of foreclosure if you default.
• There’s the temptation to overspend during the draw period (when you’re making interest-only payments).
• A HELOC is a callable loan, meaning your lender can request that you repay some or all of it at any moment. While that could theoretically happen if the residential real estate values plummet (as they did during the Great Recession), it’s more likely to occur only if you regularly miss payments or your credit score drops drastically.

 How homeowners can cope with HELOC changes

HELOCs remain a favorable way to pay for home renovations — they’re certainly a better play than running up credit card debt — but be aware of trends in residential real estate, especially in your local market. If you’re using a HELOC to borrow against your home’s equity, a significant decline in home values could cause your lender to reduce or freeze your line — as some homeowners learned during the Great Recession.

It’s not as likely to happen nowadays. “Lenders have built in a bigger margin of safety, often requiring homeowners to retain a 10 percent to 20 percent equity stake,” says Greg McBride, Bankrate’s chief financial analyst. “But if home prices have a sustained slide, they’ll be quick to cut or freeze home equity lines as we saw in 2008.”

So how can homeowners cope? “In a rising interest rate market, like the one we are in, I have been advising my clients to only draw as much on their line as they can safely and quickly pay back, or lock in the loan balance and rate into a home equity loan,” says Nicole Rueth of OneTrust Home Loans. Unlike a HELOC, a home equity loan allows you to borrow a set amount all at once and then repay at a fixed interest rate, so there’s less concern that the lender will adjust the amount of equity you can tap should home prices fall.

Final word on HELOCs and falling home values

The bottom line: A HELOC comes with strings attached, and weakness in the housing market could spur lenders to change the original terms of the loan in a way that they can’t with mortgages. Because of this, it’s smart to have a backup plan – especially if you’re in the midst of a major home renovation project – in case you can’t pull out as much money as your lender originally approved.