During the heyday of the housing market back in 2005 and 2006, when home prices were skyrocketing and credit standards were so loose that homeowners could borrow 100 percent or more of their home value, consumers were encouraged to take out a home equity line of credit (HELOC).
"In the mid-2000s, HELOCs were offered to homebuyers and owners almost in a 'would you like fries with that?' way," says Brian Koss, executive vice president with the Mortgage Network in Danvers, Massachusetts.
Today, those HELOC borrowers are facing a potential spike in their monthly home equity line payments because the initial phase, known as the "draw period," for these loans is ending and the balance is being converted into a fully amortizing loan.
"HELOCs typically operate like an open-ended line of credit accessible with a credit card or a check during the draw period," says Eric Rotner, vice president and mortgage banker with Commerce Home Mortgage in Walnut Creek, California. "During the draw period, borrowers can make an interest-only minimum payment. Once the draw period ends, the credit line freezes and borrowers have to repay the loan balance including principal and interest payments within a defined period of time, such as 10 to 20 years."
Most HELOCs have an initial draw period of 5, 10 or 15 years, with the most common period being 10 years. The average repayment term is 15 years.
"HELOC loans proliferated in 2005 and 2006, so now those loans have reached the end of the draw period and must be repaid," says Rotner.
Many borrowers who have been making a minimum payment for 10 years have forgotten their loan terms and could be surprised by the increase in their required monthly payment, says Koss.
"If you have a HELOC, find your original papers now or contact your lender to see what your repayment schedule is and to find out when your draw period ends," says Koss. "You don't want to be surprised that you can't write any more tuition checks when your kid is halfway through college."
Why HELOC payments will hurt
Since HELOCs typically have a variable interest rate, borrowers have recently benefitted from historically low rates.
For example, according to Rotner, on a $100,000 HELOC:
- Interest-only payments are $354 at 4.25 percent
- Principal and interest payments are $752 at 4.25 percent
- Principal and interest are $844 at 6 percent
3 HELOC options for homeowners nearing a reset
The good news is that rising home values provide options for many borrowers who have a HELOC that’s due to reset:
No. 1: Take out a new HELOC
If you still need access to your home equity or you need a longer period of flexibility in repaying your loan, Koss says you may qualify for a new HELOC to include the old balance and extend your draw period.
"This kicks the can down the road in terms of repaying your loan, but for borrowers who qualify this could be a viable solution," says Rotner.
No. 2: Refinance your first mortgage and your HELOC
"Low mortgage rates and rising property values allow a lot of borrowers to refinance their two loans into one new mortgage with the added benefit of a fixed interest rate," says Rotner.
Consolidating the loans into a fully amortizing loan is likely to increase your current monthly payments, but it will probably be less than if you repaid the loans separately, he says. Refinancing into a 30-year loan avoids a potential rate hike and offers the benefit of a longer repayment period.
No. 3: Ask for a loan extension
Borrowers who lack the equity or the ability to qualify for a new loan because they have credit challenges or their income is lower than in the past have the option of repaying their HELOC at the higher payment level until they can refinance. If you can't make the payments, Koss suggests asking the lender for a longer repayment term.
"The lender has a vested interest in having you repay that loan, especially because your HELOC lender is the second lien holder," says Koss.
If you default on the loan and end up facing foreclosure, the second lien holder is less likely to be repaid if there isn't enough equity in your property.
You will need good credit
Qualifying for a new HELOC or refinancing your loans together typically requires a credit score of 700 or above, says Rotner. Your debt-to-income ratio, which compares your monthly minimum payments on all debt to your monthly gross income, should be a maximum of 40 to 45 percent depending on the lender, he says.
The wave of higher HELOC payments is likely to recede after 2016 or 2017, Rotner says.
"The HELOC market vaporized and was borderline nonexistent between 2007 and 2010 and even when the loans started to make a comeback they were not as risky," he says. "Lenders are much more careful about creditworthiness and people are more cognizant of the repayment rules."
Today's borrowers typically can only borrow up to 80 percent of their home value combined between their first and second loans, says Rotner. He says borrowers with excellent credit who own homes where prices are stable or rising can sometimes borrow up to 85 or sometimes 90 percent of their home value.
"The most important thing a borrower can do is to get ahead of the problem and contact their lender a year or more before the repayment period begins to review their options," says Rotner.