Home equity borrowers, beware: Substantial “payment shock” could be coming soon to a mortgage near you.
Many home equity lines of credit (HELOCs) taken out in 2005—just as home prices were peaking—may be nearing the end of their 10-year, interest-only payment periods. With a rise in interest rates likely coming soon as the Federal Reserve winds down its easy money policy, monthly payments on these variable-rate loans could soon soar for millions of Americans.
If you’re in this situation, you may be able to avoid a potential financial disaster by refinancing into a fixed-rate mortgage or a new HELOC, or by enrolling in the Federal Housing Administration’s Short Refinance program. But first, review the full details on your loan to make sure you know what may be coming, or contact your lender to bring you up to date.
A real threat
Most HELOCs come with an “end of draw” date, which refers to the point at which you no longer can borrow against the credit line and, if you haven’t already started, must begin repaying the principal along with interest. At that point, your monthly payment can jump significantly.
The end of draw is approaching for many such loans. At least 2.5 million of the credit lines are scheduled to reset to include not just interest but principal repayment over the next three years alone, according to a report from Black Knight Financial Services in Jacksonville, Florida. It says the resulting “payment shock” may average $250 a month or more.
Americans’ appetite for HELOCs peaked in 2005. More than $180 billion in credit lines were established that year, just before home prices began to fall, according to a report by the Federal Reserve Bank of New York.
Let’s say your HELOC dates from 2005 and has a balance of $100,000 at 5.5% interest. During the 10-year, interest-only period, you paid about $458 a month. But you’re entering the 15-year period that requires you to start paying down the principal too. That will mean the monthly payment will climb by $359, to $817—an increase of about 80%. And that’s assuming the loan rate doesn’t rise as well.
As the Fed prepares to tighten credit, borrowers should also consider what rising interest rates will mean. HELOCs typically adjust when that happens, and payments rise. Using the above example, let’s say credit costs surge and your rate jumps to 8.5%. That would tack another $168 on your payment, making it about $985—more than double the interest-only payment at 5.5%.
Because the loan is secured by your home, HELOC rate increases are capped, so the payment can only rise so much. But you still could face a double whammy of principal payments beginning just as rates climb. Failing to pay could result in foreclosure, so borrowers shouldn’t take this prospect lightly.
What you can do
If you’re unsure what to expect, ask your lender for guidance. Some HELOCs require the immediate repayment of the outstanding balance when the draw period ends, which can create an even bigger headache.
If you’re nearing the end of an interest-only draw period and would rather not cope with bigger payments or a full payoff, consider refinancing the balance with a new HELOC, which will provide you with a fresh interest-only window, says Don Maxon, a certified financial planner in San Rafael, California.
Another option is to roll the HELOC into a refinanced mortgage at a fixed rate, Maxon says. This lets you lock in historically low mortgage rates for the term of the debt.
“Combining both loans into a fixed-rate loan would eliminate the HELOC interest-rate risk and the resulting higher payments,” Maxon says.
What you must come up with each month may still rise, however, since it will include paying down the HELOC principal as well as the balance of your first mortgage. Still, your total interest costs will likely be lower, and your monthly payment won’t change over the life of the loan, according to Matt McCoy, a senior financial planner at Kumquat Wealth in Chattanooga, Tennessee.
“You need to compare the fixed-rate payments to a rising-rate scenario under the current variable rate,” McCoy says. “Payments on fixed-rate loans are much easier to budget for long-term, since your interest rate does not fluctuate.”
However, housing prices were generally higher in 2005, so refinancing might be hard, if not impossible, especially for those with lower credit grades. Lenders often cap what can be borrowed against a home at 80% of its market value and have tightened up on risk tolerances for borrowers.
If you’re not behind on your mortgage payments, but feel that you can’t keep up and owe more than what your home is worth, an FHA Short Refinance may be an option. This federal program is designed to help financially underwater homeowners obtain a more affordable mortgage. But the lender has to agree to “forgive,” or write off, at least 10% of what you owe.
This article first appeared on USAToday.com.
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