For the first time in more than a decade, home prices are falling. Values in some once-hot markets have already dropped nearly 10 percent from their peaks in early 2022.
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. Could that happen again this time?
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.
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 owe $200,000 on your mortgage, you could tap up to $160,000 with a HELOC.
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 amount of $160,000, your total would be $142,000.
A HELOC is a line of credit, meaning 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.
What happens to my HELOC if my home loses value?
Economists widely expect this housing slowdown to be a correction rather than a crash, and 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 its new value.
“Some lenders may decide to cap the amount of the HELOC you can use,” says Steinfeld.
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 and disadvantages 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 — is no longer appealing. Why would a homeowner give up a loan at 3 percent for one at 7 percent?
However, HELOCs do have a few downsides. The rates are typically variable, so they can rise. A HELOC is also a callable loan, meaning your lender can request that you repay some or all of it at any moment. Don’t worry about that scenario too much, though — that move typically is reserved for cases when a borrower misses payments or experiences a decline in credit score.
Still, as some homeowners learned in 2009 and 2010, 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.
“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.”
HELOCs remain a favorable way to pay for renovations — they’re certainly a better play than running up credit card debt — but be aware of what could happen to prices in your market, and always keep your repayment strategy in mind.
“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.
This article originally appeared here and was republished with permission.