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Only 17 percent of the public thinks now is a good time to buy a house, according to the most recent Fannie Mae Home Purchase Sentiment Index. The combination of inflation, softening-but-still-high prices and elevated mortgage interest rates makes purchasing seem pretty unaffordable. But if you can’t buy a new home, why not remodel the one you have instead?
That seems to be the rationale, at least in part, for people using their home equity for financing — borrowing against their ownership stake, in other words. Data from TransUnion shows a 47 percent increase in the origination home equity loans and a 41 percent uptick in their cousins, home equity lines of credit (HELOCs), in the third quarter of 2022.
Even though these loan rates (like all interest rates) have been rising, the surge in home equity borrowing seems poised to continue in 2023. Here’s what’s behind it, and what you should know if you are tempted to join the trend.
- What: A home equity loan is a fixed-rate type of debt that allows you to borrow a lump sum based on the amount of home equity you have. A home equity line of credit (HELOC) is similar, but it has a variable interest rate, charged on funds you draw against a set balance (like a credit card). Like a mortgage, both these loans use your house as collateral.
- When: In 2022, the number of home equity loan originations reached their highest level since 2010, according to data from TransUnion. There were 322,537 originations in Q3, vs 220,144 in Q3 2021. The number of HELOCs opened was 405,646, vs 286,925 the previous year. In Q4 2022, HELOC balances increased by $14 billion collectively, according to figures from the Federal Reserve Bank of New York – the largest increase in more than 10 years. The total outstanding HELOC balance is now $336 billion.
- Why: The pandemic fueled a huge increase in housing prices across the country, hitting a record high of $47.7 trillion in total value in the middle of 2022, according to Redfin. So, homeowners are sitting on a lot more equity, with their ownership stake worth a lot more. It's tempting to tap this source when the need for funds arises: to renovate a home, to pay off credit card balances or other loans.
- Why it matters: An increase in home equity lending is paralleling a decrease in the number of home sales, as homeowners who've locked in record-low mortgage rates are opting to stay put and remodel instead of moving. But it could also mean homeowners getting into increasingly dangerous debt.
Why are borrowers tapping into their home equity?
With borrowing costs going up, why are homeowners taking advantage of HELOCs and home equity loans? Largely because they can. The pandemic-fueled real estate boom has led to lofty ownership gains in the past two years. About half of homeowners who have mortgages are in so-called “equity-rich” territory, meaning their outstanding loan balance is only half or less than what their home’s worth, ATTOM reports.
As to their motives: Many people are tapping into their home equity to spruce up their homes, and better equip them to meet their family’s needs. A December 2022 survey conducted by loanDepot, a non-bank mortgage lender, revealed that 59 percent of people listed upgrades and renovations as their most likely use for HELOC funds.
“Homebuying activity is slowing down dramatically,” says Rick Sharga, executive vice president of Market Intelligence with ATTOM. “With more homeowners deciding to stay in place, there will probably be more home improvement projects being done, and HELOCs are a relatively affordable way to pay for those projects.” And also a tax-advantaged one, in some cases (more on that later).
Some savvier homeowners might also be trying to get a lead on this slowing housing market. As home price gains moderate and mortgage rates rise, the equity opportunity will shrink with it. Taking out a home equity loan makes more sense than a cash-out refinance (in which your mortgage includes a lump sum to play with) these days. The mortgage refinancing rush that marked much of 2020 and 2021 netted homeowners some of the lowest rates on record — a deal many aren’t willing to give up any time soon.
“Many borrowers have now locked into historically-low rates on their first mortgage, which makes a cash-out refinance a costly option for tapping the equity in the home,” says Adam Boyd, senior vice president, head of Home Equity Lending at Citizens Bank — “even if mortgage rates eventually come back down somewhat.”
In other cases, homeowners might be aiming to use home equity to pay off high-interest credit card debt, notes CFA Greg Greg McBride, senior vice president and chief financial analyst at Bankrate. A 7.5 percent rate on a HELOC or home equity loan is a much better deal compared to the 20 percent APR attached to the average credit card.
Outside of credit cards, there are plenty of other reasons that tapping home equity may make sense. For example, if you’re paying off a big/high-interest personal loan or auto loan, a home equity loan might be a lower-cost way to work toward eliminating that balance. Additionally, if you’ve incurred any major expenses – medical bills, for example – a home equity loan or HELOC may be able to help save you money or simply consolidate all your debts into one convenient monthly payment.
What does the home equity loan boom mean for the housing market?
It could mean a lot more remodeled homes, for starters. And fewer homes hitting the market, as people hunker down and upgrade instead of moving. “More homeowners have postponed the idea of buying another place indefinitely — especially if they have a mortgage rate below 4 percent,” says McBride. “Upgrading or expanding where you are has become the most viable option for many homeowners.”
However, the borrowing costs for making those upgrades in 2023 aren’t nearly as cheap as they were in 2022. For example, rates on 10-year HELOCs averaged 5.49 percent in July of 2022. In February of 2023, Bankrate data showed average rates above 7.7 percent on HELOCs and fixed-rate home equity loans.
“Tapping your home equity is no longer a low cost source of funds,” McBride says. “In all likelihood, rates are going to increase further, too.”
There is one bright spot, though: If you use a HELOC or home equity loan for housing-related repairs or remodels, the interest can be tax-deductible.
Your house is on the line
Another potential concern of the equity borrowing boom: More homes could wind up in foreclosure or in financial straits, due to homeowners borrowing blithely without fully realizing the consequences. McBride points out that paying off credit cards or other debts with a home equity loan puts the roof over your head on the line.
“When you take unsecured credit card or personal loan debt and secure it with your home, the consequences of default are a whole different ball game,” McBride says. To put it bluntly, you could lose your home — as collateral for the loan, it can be seized to pay off your debt.
Equity values could fall
Admittedly, that’s a worst-case scenario. But be aware that if home values fall, your house could be worth less than all the outstanding mortgage(s) on it, a situation known as “being underwater.” This means you owe more than your home’s worth — you have “negative equity,” in real estate-lending lingo.
In some parts of the country, the share of seriously underwater homes – defined as having a balance of loans that are worth at least 25 percent more than the actual property value – has already been rising. For example, according to a recent report from ATTOM, more than 7 percent of mortgaged homes in Missouri fell into the seriously underwater category in the fourth quarter – up from 5.2 percent just a quarter earlier.
Some homeowners in other parts of the country can expect to see a drop in their equity levels. Redfin data shows that the total value of the housing market in the U.S. lost more than $2 trillion between a peak in June of 2022 and the end of the year. The nearly 5-percent value decline is the biggest drop since 2008 – a date that lives in infamy for real estate.
No one is predicting a Great Recession-like crash in the housing market. But the point is: Nothing rises forever, and it’s dangerous to take on excess debt on the assumption that it does.
How to get the best home equity lending rate
Whether you’re hoping to add on a new kitchen or pay off that oversized credit card balance, a HELOC or home equity loan still presents a potentially less-expensive means to those ends. While there are differences in how each product works, the process of shopping around for one remains the same. Here are some tips:
1. Calculate your equity
You know your home’s value has gone up, but you’re not sure where exactly you stand. Estimate your home’s equity by taking the difference between the value of your home and what you still owe on your mortgage. The best determination of value would come from a licensed appraiser, but for a rough idea, look at an online home price estimator like Zillow’s Zestimate. Once you have a number, find your mortgage balance on your most recent statement, and do the math.
Keep in mind: You can’t borrow it all. Most lenders limit you to 80 percent or 85 percent of your equity. For example, if your home is worth $380,000 and you still owe $120,000 on your mortgage, you’d be able to access up to $184,000 (assuming you qualify).
2. Get your credit in excellent shape before you apply
Home equity financing requires a pretty strong financial profile, especially for lines of credit: median credit score of successful HELOC applicants is around 775, according to the Urban Institute. While some home equity lenders do approve applicants with lower credit scores, the rule that applies to every loan still rings true: Borrowers with higher credit scores always secure the lowest rates.
If you don’t know your credit score/history, start there. The three major credit reporting bureaus, Equifax, Experian and TransUnion, now allow you to access your reports free on a weekly basis through 2023.
If your score isn’t 700 or higher, take steps now to improve it by staying on top of payments and lowering your credit utilization ratio to no more than 30 percent of your limit, at max. It can take some time for your score to change, so the sooner you start, the better.
“It would not be uncommon for a 20-point move in FICO score to impact pricing by 0.50 percent to 1.50 percent, especially for borrowers with sub-700 FICO scores,” says Adam Boyd, senior vice president, head of Home Equity Lending at Citizens Bank. “I would encourage borrowers to shop around to find the best offer.”
3. Start your search where you’re already doing your banking
While there are several types of home equity lenders, begin with the place you already know: your bank or credit union. A lot of institutions offer rate discounts — 0.25 percent or 0.5 percent savings — for customers who set up auto-pay from checking or savings accounts. Check out an offer or two from an online-only lender, as well — if eligible, you might be able to get your funds sooner, or for a lower cost.
4. Look for conversion options
Interest rates are still on the rise, thanks to the Fed’s continued fight to tame inflation, which is especially bad news for variable-rate products like HELOCs. Some lenders, however, allow borrowers to convert a line of credit to a fixed-rate loan. For example, you might opt to switch over $25,000 of a $75,000 HELOC to a fixed-rate loan to avoid the shock to your budget down the road.
5. Read the fine print
While home equity loans and HELOCs tend to have significantly lower fees and closing costs than first mortgages, McBride still recommends comparison shopping and paying close attention to the loan proposal’s fine print. For example, some lenders will offer to cover the closing costs on a HELOC with a minimum time commitment.
“A lender might cover the costs as long as you maintain the line of credit for three years,” McBride says. “You don’t want to close it in two and a half years and then get hit with all those expenses.”