As debt mounts, is it worth tapping a home equity line of credit?

The holiday season usually means Americans are running up their credit card debt. Come January, lenders are typically fielding a plethora of inquiries for home equity lines of credit for people seeking to consolidate their debt.

A home equity line of credit or HELOC may help you to coral debt, knock credit card interest rate down and improve a cash-flow situation.

First, consider the credit card challenge driven by inflation and depleted savings.

The average American owes somewhere between $6,300 and $7,500 in credit card debt, depending on the data source.

As of December, the average credit card interest rate is nearly 24%, according to Lending Tree.

As of the third quarter, Americans owe $1.23 trillion in credit card debt, an all-time high, the New York Fed says. That’s an increase of $24 billion from just the previous quarter.

Those of us who are homeowners have the good fortune of potentially tapping home equity through several financial instruments. Today, I am focusing on HELOCs.

What is a HELOC?

A HELOC is a revolving line of credit, like a credit card that allows you to borrow against the equity in your home. Equity is your property value minus any mortgage debt on the home.

Dissimilar to a credit card, your lender uses your home as collateral. In the event you don’t pay, the lender can foreclose on your home to pay off the HELOC debt. Because of collateral protection, HELOC lenders charge a lot less in interest, about one-third of what credit card lenders charge.

Although I’m focusing on consumer debt, there are lots of other reasons for folks to use HELOCs. Funds are used for home improvement, paying off student loan debt or other debt consolidation like car loans. Others may use a HELOC to tap equity for a down payment on another property.

If you are using the money for home improvement or purchasing another business investment like rental property, for example, the interest is tax deductible.

As an aside, whether you have other financial needs or not, the most important reason to have an available HELOC is ICE (in case of emergency, in this case), especially since some HELOCs are available without cost.

Key HELOC components

The index: Most HELOC lenders use Wall Street’s prime rate. This week the Fed reduced short-term rates by 0.25%. So, the prime rate is 6.75%.

Lender’s profit margin: This, added to the index, sets the borrower’s rate.

Margins never change. The index does change. So, when the Fed raises or lowers rates, the prime rate changes and tracks to that change. HELOCs are always adjustable.

Let’s say a lender was offering prime rate plus a 2% margin. That means your interest rate is 8.75% (6.75 plus 2). Let’s say another lender was offering you an introductory rate (industry vernacular is called teaser rate) of 5% for six months. But then the rate jumps to prime rate plus 2.5% or 9.25% in the seventh month.

If you think you are going to hold onto that HELOC for, say more than one year, you should take HELOC without a teaser rate.

As far as pricing goes, some banks and credit unions may offer no-cost or no-closing cost HELOCs. Others may charge from 0 to 4 points plus other closing costs. One point is 1% of the loan amount. For example, 2 points on a $200,000 loan amount would be $4,000.

Be mindful though. In my experience banks tend to be a little more conservative in terms of credit scores, underwriting requirements, the collateral requirements and appraisal value. So, the cleaner your deal, the more likely you’ll find a zero cost HELOC.

Some HELOCs have a floor and a ceiling, whereas the rate can never go below X when considering the index plus margin or above Y (usually 18% is the cap).

HELOCs do not offer monthly or yearly rate caps except for an introductory rate.

HELOCS allow you to pay interest-only for up to the first 10 years. You can also borrow and payback during that 10-year period so long as funds remain on your HELOC.

For the remaining years (10,15 or 20), the lender will amortize the payment using the remaining balance at the current interest considering the number of months left.

Other points to consider

Does the HELOC have a prepayment or early payoff penalty? Some have them and some do not. Ask. If so, how much?

Does the HELOC have an annual fee? Most HELOCs do charge an annual fee. Again, ask. If so, ask how much.

Do not confuse a HELOC with a fixed rate second mortgage, also known as a HELOAN. That is a type of second lien at a fixed rate, but you can’t borrow incrementally. However, you can pay back some or all the funds early without a prepayment penalty. You must take all the funds upfront. HELOAN works best for someone who already has an outstanding balance to pay off and doesn’t need any other funds.

If you need help comparing HELOCs you are welcome to email me the particulars. I will give you my 2 cents. I advise you to shop with three different lenders.

Freddie Mac rate news

The 30-year fixed rate rose to 6.22% from 6.19% last week. A year ago, the rate averaged 6.6%. The 15-year fixed rate also rose, climbing to 5.54%, up from 5.44% last week. A year ago, it averaged 5.84%, Freddie Mac said.

The Mortgage Bankers Association reported a 4.8% mortgage application increase compared with one week ago.

What I see: Locally, well-qualified borrowers can get the following fixed-rate mortgages with one point: A 30-year FHA at 5.49%, a 15-year conventional at 5.25%, a 30-year conventional at 5.875%, a 15-year conventional high balance at 5.75% ($832,751 to $1,249,125 in LA and OC and $832,751 to $1,104,000 in San Diego), a 30-year high balance conventional at 6.25% and a jumbo 30-year fixed at 6.25%.

Eye-catcher loan program of the week: A 30-year mortgage, fixed for the first five years at 5.375% with 30% down payment and 1 point cost.

 Jeff Lazerson, president of Mortgage Grader, can be reached at 949-322-8640 or jlazerson@mortgagegrader.com.