Home equity borrowers beware: a substantial “payment shock” could soon be hitting a mortgage near you.
Many home equity lines of credit (HELOCs) taken out in 2005 — just when house prices peaked — could be approaching the end of their 10-year interest payment periods. With an interest rate hike likely imminent as the Federal Reserve ends its easy money policy, monthly payments on these variable rate loans could soon skyrocket for millions of Americans.
If you are in this situation, you may be able to avoid potential financial disaster by refinancing a fixed rate mortgage or a new HELOC, or by enrolling in the Federal Housing Administration’s short-term refinance program. But first, review all the details of your loan to make sure you know what may happen, or contact your lender to keep up to date.
A real threat
Most HELOCs come with an “end of draw” date, which refers to when you can no longer borrow against the line of credit and, if you haven’t already started, must start repaying the principal. with interest. At this point, your monthly payment may increase significantly.
The end of the drawdown is approaching for many of these loans. According to a report from Black Knight Financial Services in Jacksonville, at least 2.5 million lines of credit are expected to be reset to include not only interest but principal repayments over the next three years. He says the resulting “payment shock” can average $250 per month or more.
Americans’ appetite for HELOCs peaked in 2005. More than $180 billion in lines of credit were established that year, just before home prices began to fall, according to a Federal Reserve report. Bank of New York.
Let’s say your HELOC is from 2005 and has a balance of $100,000 at 5.5% interest. Over the 10-year period, interest only, you paid approximately $458 per month. But you enter the 15-year period which also requires you to start repaying the principal. This means the monthly payment will jump from $359 to $817. And that’s assuming the lending rate doesn’t increase as well.
As the Fed prepares to tighten credit, borrowers should also consider what rising interest rates will mean. HELOCs usually adjust when this happens and payouts increase. Using the example above, let’s say the cost of credit increases and your rate drops to 8.5%. That would add another $168 to your payment, or 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 increase so much. But you could still face a double whammy of principal payments starting just as rates spike. Failure to pay could result in foreclosure, so borrowers should not take this prospect lightly.
what you can do
If you’re not sure what to expect, ask your lender for advice. Some HELOCs require immediate repayment of the outstanding balance at the end of the draw period, which can create an even bigger headache.
If you’re nearing the end of an interest-only drawdown period and prefer not to face larger payments or a full refund, consider refinancing the balance with a new HELOC, which will provide you with a new interest-only window, says Don Maxon, a certified financial planner in San Rafael, Calif.
Another option is to turn the HELOC into a refinanced mortgage at a fixed rate, Maxon says. This allows you to lock in historically low mortgage rates for the term of the debt.
“Combining the two loans into one fixed rate loan would eliminate HELOC interest rate risk and the resulting higher payments,” Maxon says.
However, what you need to find each month may still increase, as this will include paying off the HELOC principal as well as your first mortgage balance. Still, your total interest charges will likely be lower and your monthly payment won’t change over the term of the loan, according to Matt McCoy, senior financial planner at Kumquat Wealth in Chattanooga, Tenn.
“You need to compare fixed rate payments to a rising rate scenario under the current floating rate,” McCoy says. “Payments on fixed-rate loans are much easier to budget for in the long term because your interest rate doesn’t fluctuate.”
However, housing prices were generally higher in 2005, so refinancing could be difficult or impossible, especially for those with lower credit ratings. Lenders often cap what can be borrowed against a home at 80% of its market value and have tightened borrowers’ risk tolerance.
If you’re not behind on your mortgage payments, but you think you can’t keep up and you owe more than your home is worth, an FHA short refinance may be an option. This federal program is designed to help financially underprivileged homeowners get a more affordable mortgage. But the lender must agree to “forgive” or cancel at least 10% of what you owe.
By knowing the terms of your HELOC and understanding all the risks when you exit the draw period, you can guard against “payout shock”.
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