How to Beat the HELOC Monster

A new report from TransUnion says Americans have home equity lines of credit -- HELOCs -- worth $474 billion. The bad news? HELOC loans worth as much as $79 billion are in danger of foreclosure.

HELOC: Easy to Borrow...

HELOCs are like giant credit cards ready to be used at a moment's notice. The catch is that home equity debt is like all debt; it has to be repaid at some point. For many borrowers with home equity lines of credit the exact repayment process is unclear and therein lies the danger: The call for repayment may be sooner and more expensive than expected.

To understand the problem, take a look at how HELOCs work. Imagine that the Smiths have a home worth $400,000, and they owe $200,000 against it. A lender comes along and offers to provide a $100,000 credit line. Combine the existing first mortgage with the new line of credit, and the property has a 75 percent loan-to-value ratio ($300,000 loans / $400,000 property value = .75, or 75 percent).

Now the borrowers have a $100,000 line of credit, but they only pay interest on the amount used. If they borrow $5,000, they pay interest on that amount, and they have $95,000 in available credit. If they repay the $5,000, the available credit line reverts once again to $100,000.

A HELOC is very much like a credit card but with several important differences: First, the credit line interest rate is likely to be far lower than credit card interest, because home equity lines of credit are secured by property.

Second, HELOC interest is likely tax deductible because -- again -- it's secured by residential real estate while credit card interest is not -- see a tax professional for details.

Third, a HELOC is really a term loan; there comes a point when it ends.

...Hard to Repay

In describing the home equity line of credit, repayment has not yet been mentioned -- yet it's an important matter.

Most HELOCs are structured in several phases. With a 15-year adjustable-rate home equity line of credit, the phases might look like this:

Phase 1: The draw period, which usually ranges from five to ten years.

Phase 2: The end of draw or EOD date.

Phase 3: The repayment period.

During the draw period, the borrower can take out and put back money at will. Any money taken out must be repaid with interest; however, the required payment might only be the interest accrued. If the Smiths use $25,000 of their credit line and their adjustable rate is 3.25 percent, the minimum payment is $67.71 (3.25 percent / 12 months, multiplied by $25,000).

In five years, the Smiths' draw period ends and the debt must be repaid during the remaining ten years of the loan's term. This is called the repayment period.

The Smiths now have a $25,000 debt at 3.25 percent for ten years. The required monthly payment is $244.30. And that's assuming that this interest rate didn't increase at all during this time. It's an adjustable rate, which means it could increase or decrease. An increase would hardly be unexpected, considering that in 2006 -- the year when home credit lines worth almost $75 billion were originated -- the prime rate at that time reached 8.25 percent. Those 2006 HELOCs are now eight years old, helped greatly by a huge drop in the prime rate. Suppose the rate has gone to five percent during the draw period, and now the Smiths have a $25,000 balance at five percent. The payment is $265.16.

With the end of draw period, the minimum monthly payment can explode. If the Smiths have used their entire $100,000 and their rate increases to five percent, their monthly payment is a huge $1,060.66.

Beware! It's a Different Market

According to the Mortgage Bankers Association more than 90 percent of the loans which are today seriously delinquent were originated prior to 2009. Exploding HELOCs represent another aspect of the same problem, loans originated in a period of rising prices and great expectations -- and now loans which may come due during tougher economic times.

This is especially the case for homeowners in areas of the country that experienced massive home price declines. On one hand, it is entirely true that real estate equity has increased substantially, up $4.1 trillion since 2011. It's also true that equity has yet to again reach the 2006 peak. As the National Association of Realtors has just reported, home values during the second quarter of 2014 increased in 122 metro areas -- and fell in 47.

How to Defuse a HELOC Bomb

What to do if you face an exploding HELOC? Take these steps.

First, contact your lender. Make sure you understand when the draw period ends and the length of the repayment period.

Second, run the numbers. Look at your current balance, interest rate and the monthly payments you might face. This can be done with a mortgage loan calculator and by asking your lender. Also run the numbers with the highest interest rate the lender can charge under the terms of the HELOC.

Third, if you are now in the draw period, stop taking money from the credit line and start paying down the balance.

Fourth, ask the lender if the line of credit can be refinanced into a second loan with a longer term, say 15-to-30 years. This option will substantially reduce monthly payments. Another alternative is combining your current first mortgage with the HELOC and refinancing into a single loan.

Fifth, if your current lender cannot offer an alternative, contact other lenders. See if any state or federal programs are available to help you.

Exploding HELOCs. They're real and they're dangerous, but in many cases they can be defused. Act now to protect your home and your finances.

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