HELOC Home Equity Line Of Catastrophy

HELOC Home Equity Line Of Catastrophy

A large percentage of home owners still have sizable balances on their lines of credit, because interest rates have been at all-time lows for most of 2009.  While the money is currently cheap, unaware homeowners could be sitting on a potential powder keg.  Home Equity Lines of Credit or HELOCs, as they are referred to in our industry, are an incredible financial tool. The ease of monetizing the equity in your home, which has traditionally been illiquid, has made these mortgage instruments hugely popular over the last decade. They have become a wonderful emergency piggybank and saved many a homeowner hitting a rough patch.

There are several characteristics of these mortgage instruments that unfortunately may surprise the average home owner. HELOCs are very similar to credit cards: They are based on adjustable rates that move up and down with economic trends; there is usually an interest only payment feature allowing the borrower to pay very little if any of the outstanding balance; and they are usually based on a volatile index which will react quickly to a change in the economic environment. Unlike regular Adjustable Rate Mortgages (ARMs), HELOCs do not have annual rate caps; furthermore, the life caps range from 12% to 18%. So what does that mean in dollars and cents?  See the chart below to see what a HELOC based on Prime rate with an $85,000 balance and a 0.5 margin, costs you monthly at various rates.

Here are the various monthly HELOC payments at the respective prime rates if rates were to increase: prime rate – monthly payment 3.25% – $265.00, 5.5% – $425.00, 8.0% – $602.08, 11.5% – $850.00, 17.5% – $1275.00. Prime rate is currently at 3.2%

As you can see small increases in the rate translate to some pretty big jumps in payments. These are budget busters for many people. What is surprising is that most people do not realize that prime has been over 8% three times in the last 15 years and was over 18% in the 1980’s. These are possible scenarios over the next four years.

Finally, most, if not all HELOCs have a recast feature. This little surprise usually happens in the tenth year of a line of credit when the line turns from an interest only loan into a 15 year fully amortizing loan. In the example above the $850.00 a month interest only payment when prime is at 11.5% would move to $1020 overnight.

My advice: make sure you have a strategy in place when rates move up! This would entail having enough liquid cash to pay down your balance substantially or having enough monthly income to cover your payment increases. If neither of these two options are possible for you, refinancing now while fixed rates are at historical lows should be a consideration.

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