Homeowners tap home equity at fastest pace since 2005

Homeowners tapped their home equity lines of credit at the highest rate in more than two decades in the third quarter, CNBC reported, citing a Federal Reserve Bank of New York report.

Balances on HELOCs jumped by $23 billion during the three months ending Sept. 30, the largest increase since 2005. That brings the outstanding amount owed to $481 billion. It is the 18th consecutive quarterly increase. HELOC balances peaked at roughly $714 billion in the first quarter of 2009, during the housing bubble’s aftermath, and then declined for years as homeowners paid down debt and lenders tightened standards. The current rise reflects a different dynamic: homeowners are not extracting equity to fund consumption, they are extracting it because they cannot move.

The mortgage rate lock-in effect is the driver. Just under half of outstanding mortgages, 49.1 percent, carried rates of 4 percent or lower in the second quarter, according to a Realtor.com analysis of federal mortgage data. The average rate on a 30-year fixed-rate mortgage is 7.3 percent as of Tuesday, according to Mortgage News Daily. Homeowners who sell their current home to buy another one give up a 3 percent mortgage for a 7.3 percent mortgage, and the monthly payment difference on a typical loan is large enough that staying put is the rational choice. So they stay, and they tap their equity instead, a trend documented across U.S. housing markets.

Douglas Boneparth, a certified financial planner and president of Bone Fide Wealth in New York City, told CNBC that HELOCs let owners borrow against their equity without giving up the low interest rate on their primary mortgage. “HELOCs let them borrow against their equity without giving up the low interest rate on their home,” Boneparth said. That is the trade: keep the cheap mortgage, take on a variable-rate line of credit at 7.49 percent, and use the proceeds for home improvements, debt consolidation, or other needs.

The equity is there to tap. Mortgage holders collectively had $17.5 trillion in home equity as of the third quarter, according to a report from Intercontinental Exchange. Tappable equity, meaning the amount a homeowner can access while keeping at least 20 percent equity in the home, rose 1.2 percent from a year ago to an average of $204,000 per borrower. “Homeowners are sitting on substantial housing wealth, with 2.4 million mortgage holders now holding at least $1 million in equity,” Andy Walden, head of mortgage and housing market research at ICE, said in the report.

The median price of an existing home was $417,500 in September, according to the National Association of Realtors. That is up just 1.3 percent from a year earlier but nearly 54 percent higher than in September 2019. The price appreciation is what created the equity, and the lock-in effect is what makes the equity accessible only through borrowing rather than selling.

The risk is in the structure. HELOCs typically have a draw period of five or 10 years during which the borrower can take money out and is only required to pay interest. After the draw period ends, the borrower enters a repayment period of 10 or 20 years during which both principal and interest must be paid. “The real test comes when the repayment period kicks in, and the principal starts to show up, if that’s how their HELOC is structured,” Boneparth said. “Payments potentially could double overnight, and you really want to know that before you sign anything.”

The variable interest rate is the other risk. The average rate for a $30,000 HELOC was 7.49 percent as of Nov. 4, according to Bankrate. HELOC rates are tied to the prime rate, which moves with the federal funds rate. If the Federal Reserve hikes rates by 50 basis points in December, as some traders are now pricing, HELOC rates go up with them. “If your budget only works at today’s rate, then your budget doesn’t really work,” Boneparth said.

What I think

The $23 billion quarterly increase is not a bubble signal. It is a rational response to a distorted market. Homeowners have $17.5 trillion in equity and an average of $204,000 in tappable equity per borrower. They cannot access that equity by selling because selling means giving up a 3 percent mortgage for a 7.3 percent mortgage. So they access it by borrowing, and the borrowing is expensive but less expensive than the alternative. The lock-in effect is not going away as long as the Fed is hiking, and the Fed is hiking because inflation is not dead. The HELOC balances will keep rising.

The risk is in the reset. The 18th consecutive quarterly increase means that some HELOCs are approaching the end of their draw periods. When the draw period ends and principal payments begin, the monthly payment can double. If rates have also risen during the draw period, the payment shock is even worse. The homeowner who took out a HELOC five years ago at 5 percent is now paying 7.49 percent, and when the principal amortization kicks in, the payment goes from interest-only to fully amortizing. That is the moment that defaults happen.

Boneparth’s warning about using HELOCs to pay off credit card debt is the one that should get more attention. Credit card debt is unsecured, which means the worst outcome is a damaged credit score. HELOC debt is secured by the home, which means the worst outcome is foreclosure. Converting unsecured debt to secured debt is a rational move if the homeowner has fixed the spending problem that created the credit card debt. It is a dangerous move if they have not, because they have just put their home at risk for a problem that will recur. “You’re just moving the problem somewhere a little scarier,” Boneparth said, and he is right.

The $481 billion in outstanding HELOC debt is still well below the $714 billion peak from 2009. The system is not leveraged the way it was before the financial crisis, and lending standards are tighter. But the direction is clear: balances are rising, rates are rising, and the Fed may hike again in December. Each of those trends makes the payment shock worse when it arrives. The homeowners who are borrowing against their equity today are making a rational choice given the constraints they face. The question is whether they will be able to afford the payment when the constraints tighten.