Tag: HELOC

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Ask an Ex-Banker: HELOCs – Friend or Foe?

Michael,

I read your columns weekly. I was surprised, taken aback, and disappointed in your opening sentences in a recent column.

You knew you had RE taxes to pay in January but apparently didn’t save (I call this self-escrow) during the year. It’s my belief that people read your columns and look to you as a knowledgeable resource and someone who would provide good guidance.

To not save in advance of a known annual obligation and to, willy-nilly, say “We have a home equity line of credit…” [aka a HELOC] is to enable most homeowners to do the same and then to incur interest cost on the balance. This creates a never ending cycle of debt since the homeowner would not likely have the excess funds to both pay off the balance due and save for the next year. Instead, homeowners are encouraged to not save in advance. What about homeowners that don’t have a HELOC?

I’m disappointed. Thoughts?

Warm regards, Larry Estes, Houston TX

Michael,

On a recent visit to my local bank the Branch Manager inquired if I had an Equity Line of Credit. I understand the concept. I can use an amount of equity in my home to pay for whatever and pay back the bank over time at some rate of interest. I recall seeing one of your recent articles in the Sunday Houston Chronicle about paying a tuition payment using an equity line of credit. What are the good, bad, and ugly benefits and issues with an equity line of credit? My banker showed me an example of $50K for 60 months at 8% interest.

Pete Thompson, The Woodlands

Hi Pete and Larry,

These are great questions & comments. I am a big fan of HELOCs, which I mentioned recently in a story about paying my real estate taxes. 

Willy-Nilly Condoning Irresponsible Behavior

To address Larry’s criticism head-on:

Yes, the best scenario for paying bills is to always have sufficient savings on hand for expenses, and to not use any debt. No arguments there. That just isn’t a world in which I currently live. So, we make different choices. My choices may appear to be giving permission to readers to be willy-nilly incurring debt and living beyond their means. But that isn’t my intention. So, readers, to be clear, try to pay for everything with savings. For the rest of you, the HELOC can be a tool, however imperfect, that is better than the alternative.

First, some definitions. “Home equity” is the difference between how much a home is worth and how much debt – usually a first mortgage – is on the home. If your house appraised at $300 thousand and you owe $200 thousand in a first mortgage, we say that there is $100 thousand of home equity. When home values go up, that creates the happy situation of additional home equity which then provides the collateral against which home equity loans or home equity lines of credit may be offered. Lenders are most often comfortable making 80 percent loan-to-value real estate loans. You can probably get a competitive interest rate on a $40 thousand HELOC in this scenario, since it stays within the 80 percent of home value rule.

Home equity lines of credit are revolving, meaning you can draw down and pay back the line – just like a credit card – as often as you like for a period of time, which is normally between 5 and 15 years. This makes it extremely convenient as an emergency back-up financial tool. The best and highest use for a HELOC is to have it in place, but to never draw down on it, unless an emergency or extraordinary opportunity arises. 

Another version of this, which Pete’s banker may have been pushing, is a home equity loan (aka a HEL). This is far less attractive and useful than a revolving HELOC, in my experience and opinion. It’s just a second mortgage, and you get one if you must, but it isn’t as flexible, because it does not “revolve,” allowing for infinite drawdowns and paybacks.

If the choice is between paying for something in an emergency using a credit card versus paying for something using a HELOC, the preferred answer is almost always the HELOC. The interest rate currently should be in the 8 to 9 percent range, as compared to a 12 to 29 percent range for a credit card. 

At the extreme end of the spectrum if you plan to default on your debts, a credit card would be better than a HELOC, since defaulting on a credit card only wrecks your credit, whereas defaulting on a HELOC could jeopardize ownership of your home. But I’m mostly assuming in a comparison between a credit card and a HELOC that you have a reasonable plan for paying off your debts in the long run, rather than defaulting on them.

Dangers

Because this is, like a regular mortgage, debt backed by the collateral of your home, you are putting your shelter at risk if you default. Do not do this lightly. In the 2008 mortgage crisis, HELOCs and HELs wreaked havoc with people’s personal finances, when they lost their job, defaulted on their debts, and faced foreclosure. Banks and investors similarly took massive losses on the portfolios of HELOCs and HELs they had extended. Debt is always somewhat dangerous, use with caution.

The second danger is more subtle, but very relevant today. The interest rate on a HELOC is generally “floating” not “fixed.” So that can be great in years like 2005 to 2022 with super low rates, but also not as great in 2023 and 2024 when rates float up to 8 or 9%. HELOCs have climbed from roughly 4.5 percent a few years ago to about 8.5 percent today. We have a balance on our HELOC, it’s at 8.5 percent, and as a result I don’t love it as much as I did 2 years ago. 

Who is this best for?

There are people who must have a HELOC, people who should never have a HELOC, and then the rest of us.

People who must have HELOC: Entrepreneurs and owners of early-stage or small businesses. A HELOC is much easier to get than a small business loan, and every small business or early-stage company will struggle to get attractive, flexible, ready-to-use loans to deal with emergencies. If you are a small business owner or prospective entrepreneur, and you own a home with equity in it, then getting a HELOC is an absolutely key tool in your toolbox.

People who should never have a HELOC: If you have the pre-existing condition of constantly living above your means and maxing out your credit card, then a HELOC is going to, over time, turn this bad habit into a dangerous situation that puts your house at risk. Don’t get one.

The rest of us: If you have untapped equity in your home, and the ability to live within your means, the best type of HELOC is one in which it’s there for emergencies but you leave it unused. Since you don’t pay any interest on the untapped part of a HELOC, it doesn’t hurt you to have one set up. It’s more financially efficient to have an unused line of credit on a HELOC than it is to have an emergency fund sitting in cash. That’s kind of my long answer to reader Larry’s criticism.

A version of this post ran in the San Antonio Express News and Houston Chronicle

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Comprehension Not Disclosure

Despite all reports to the contrary, I have not suspended my campaign for National Personal Financial Benevolent Dictator (NPFBD). 

In fact, today I add a new plank to my platform.

My latest plank is regulation through comprehension, rather than through disclosure. I’ll unpack what I mean by that below.

I’m in the process of renewing the Home Equity Line of Credit (HELOC) on my house. 

As you can imagine, my mailbox and email box filled to the brim with dozens upon dozens of disclosure document pages for my signature. These are virtually unreadable and they will go unread by me. Nevertheless, I will sign them.

Lauren Willis, a law professor whose criticism of financial literacy programs I recently described admiringly, has a replacement for these disclosure documents, and I’ve stolen her idea for my platform.

She argues in a 2017 paper “The Consumer Financial Protection Bureau and the Quest for Consumer Comprehension”  that financial products regulation should focus less on disclosure and more on creating a system of consumer comprehension. 

Here’s what she means. Financial service providers – of credit cards, insurance, investments, and mortgages – would need to regularly show to regulators that a large majority of their customers could pass a simple comprehension test about their product. 

Placing the burden on financial firms to stay consumer compliant is analogous to requiring car companies to prove they can meet emissions standards, or toy manufacturers can meet child safety standards.

As long as, say, 80% of credit cards users could ace a quiz about what their interest rate is and the cost of their late fees, and maybe also what the mandatory arbitration clause means, the credit card company would be in the clear. Or, as long as 70% of insurance buyers could accurately describe the meaning of their deductible, premium, their coverage and exceptions, they are good. Provided that 85% of mortgage borrowers correctly describe in a quiz their terms and what their payments will look like if the adjustable rate changes in 3 years, the product is fine.

I’m making up these numbers and these requirements just to provide some sense of what a consumer-comprehension quiz would look like. The point from Willis is two-fold: Disclosing terms in tiny print over 30 pages never helps. It leaves the burden on the consumer. Instead, the burden should be on the firm to show – with a consumer comprehension audit – that customers know what they are buying. After all, isn’t that the original point of these non-effective disclosures in the first place? 

Our default system is free market. And I’m a free markets guy. I like classical economics’ trust that prices and quantities will reach equilibrium as long as we minimize frictions like taxes and government interference. Few people will purchase a $10 tomato when a $1 is available, says classical economics. Firms able to offer $1 tomatoes will sell many more units than a purveyor of Gucci tomatoes. I understand this concept very well.

But the last forty years of behavioral finance has taught us that classical equilibrium theory doesn’t work as well in areas like personal finance, because of predictable inherent biases and errors of thought. As a result, people are unknowingly purchasing $10 tomatoes when they should, logically, be buying $1 tomatoes. The inefficiency endures because of human error in predictable, repeatable, ways. And if we know these errors in advance we should build in protections.

And yes, regulation like this could be expensive to firms.

But the alternative is not free market efficiency. The alternative is people paying for $10 tomatoes out of predictable ignorance.

Lauren_willis
Professor Lauren Willis

As NPFBD, I am used to people not understanding the brilliance of my proposals at first glance. But I am both benevolent and a dictator, so I will further explain and address your concerns.

One objection: Some people just can’t be taught, because math is hard. And financial concepts are especially hard. Ok, true. But Willis’ proposal focuses on setting a target for average comprehension. Like maybe just seventy percent of customers have to pass the “comprehension audit.” Not everyone. Just a good majority. That seems reasonable and flexible to me.

Another objection: Comprehension seems costly for firms, as they would be required to create educational programs around their products. Maybe. But wouldn’t it also seem that firms facing the potentially high cost of consumer education would be greatly incentivized to simplify these same financial products? Wouldn’t firms pivot towards selling things that any fifth grader could understand? 

I am certain, for example, that variable annuities would rightly disappear from the face of the earth if insurance companies were forced to educate consumers about how they actually work. Because, quite simply, they cannot be explained in simple terms. 

You know what else is costly? 25% of sub-prime mortgage borrowers defaulting in the same year, sending the world financial system into a tailspin, and requiring an unlimited bailout of all of Wall Street.

Another objection: True financial complexity cannot be captured in short consumer-education segments. Willis addresses this by analogy with energy-efficiency regulation. Simple labelling with stars currently informs us consumers of energy-efficient dishwashers and refrigerators. I don’t have to be an electrical engineer to understand the energy-efficiency star system. I just need to know enough about how the labelling of stars on my dishwasher works. A simple and consistent labelling system for credit cards, mortgage, and investment products could go a very long way to building consumer comprehension.

This is a results-oriented approach to regulation. It’s not about the number of pages of fine print. It’s about proving – with reasonable room for variation – that people using the products actually know what they’re getting and at what price.

behavioral_finance

I’m knowledgeable enough about behavioral finance to know that the unfettered free market will lead to worse results for many. But I’m cynical enough to recognize that traditional financial product regulation – in the form of more disclosures – creates an ever-increasing paperwork and liability burden on businesses, but without addressing the core problem. 

I don’t read disclosures even on my own HELOC application. In fact, nobody does. This creates a “You pretend to disclose, while I’ll pretend to be protected” universal cynicism toward the regulation of personal financial products.

As your NPFBD, I’ll focus less on disclosure and more on consumer comprehension instead.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related post

My Campaign For NPFBD – Focus on retirement investing

Renewing my HELOC in 2015 – Judgement vs. Objectivity

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Judgment vs Objectivity – My Recent HELOC Renewal

A version of this post ran recently in the San Antonio Express News.

My wife and I recently renewed our home equity line of credit 1  with our bank.

nutella_is_the_best
HELOCs are as good as Nutella

When the notary at my bank had us in the room for 30 minutes busily initialing and signing many dozens of pages per a minute – pausing approximately 0.7 seconds per page – my mind began to explore the absurdity of it all.

Am I supposed to have read each page? Does this signature here actually compel my compliance with everything on the page? Really?

Hidden in the fine print of these documents, the bank probably slipped “And, henceforth I, Michael Taylor, by my signature below, do solemnly agree to wear a rubber ducky costume to work every day. Also I agree that my banker is the super-duper coolest person ever” and there’s no way I would have caught that in the fine print.

And yet, I signed. My cursive name must mean I agreed to it all. Yes, I agreed to whatever they wrote down there!

I’ve worked on many sides of the mortgage business for many years now, so I understand the point of this paperwork. To wit, the papers have zero to do with serving borrowers and 100 percent to do with creating a CYA paper trail – a paper trail that serves the lender, not me, if things go badly.

I get that.

I wish I didn’t have to participate in this charade of me ‘agreeing’ to something which I am unwilling to read thoroughly, that the bank knows I am not reading, and yet the bank also knows they can take me to court and win by arguing successfully that I agreed to all their terms, if I fail to comply with said terms.

We’ve all had that experience of mindlessly signing and initialing page after page of unread documents.

What do all those initials and signatures, the unreadable documentation, plus all of the regulatory morass that underpins it all, stand in the place of? Human judgment.

nail that sticks outWritten rules substitute for our ability, or the bank’s ability, to make individual decisions specific to a situation.

But here’s the weird thing that I returned to in the midst of signing my name dozens of times in front of my notary: this dehumanization of the decision process is a good thing. This automated decision-making process works to our advantage.

We think we want our bankers to be able to use their judgment. But we really don’t.

We think we would all be better off if we had a banker, like George Bailey from It’s a Wonderful Life, who could look us in the eye and say: “Here’s a loan, Taylors, I trust you. Don’t worry about all that boring paperwork, your handshake is enough.”

We’d skip out of the bank buoyed by Banker Bailey’s great judgment and trust in our solid character.

To the extent that George Bailey’s world ever existed (it may have, or it may not have) I don’t think that was a better world for borrowers for at least for one important reason: Borrowing costs.

All the impersonal unreadable language assists in making mortgage loans like my HELOC (Home Equity Line of Credit, but you know that) one of the cheapest ways to borrow on this planet.

Banks do not really underwrite mortgage loans anymore. Instead, they originate mortgages for a fee, and then feed the mortgage bond investor system with similarly situated mortgage loans. To feed that system, every single mortgage or HELOC must conform precisely to the standards of bond investors.

The mortgage bond market attracts a billion of dollars of investment capital on a daily basis 2 to fund home ownership. That money invested in mortgages gets offered at rock bottom interest rates precisely because of the uniformity enforced inside a mortgage bond.

Any non-conformity in the mortgage underwriting process makes the loan ineligible for inclusion in a mortgage bond structure. “The nail that sticks out must be hammered down,” as the Japanese cliche goes.

With a signature missing here or an initial missing there, the bond structuring companies would kick our loan out, and the bank would get stuck with an inefficient product on their books, which is the last thing they want.

I’ve never worked in the Wal-Mart supply chain, but I’ve read about the incredibly strict standards by which suppliers must meet packaging specifications to get their stuff into Wal-Mart stores. Those inflexible standards help produce the rock-bottom Wal-Mart prices. Human judgment or flexibility with the rules would raise prices in Wal-Mart, just as it would for my HELOC.

walmart_mortgages
All things must be automated

When my wife and I signed our HELOC recently, we were the product being packaged for sale into the mortgage bond market. We got a great interest rate, and it only required an assembly-line approach to signing everything.

 

Please see related posts

Ask an Ex-banker – Home Equity Lines of Credit

Why You Hate Your Bank – Lack of Judgment

 

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  1. By the way, home equity lines of credit are the bomb. Tangential to the following discussion, I believe home equity lines of credit – despite causing widespread financial destruction in 2008 – are the best invention since Nutella on toast. But that’s a discussion for another time and place. ↩
  2.  How do I get that number, you ask? Great question. The US mortgage bond market added up to $8.7 Trillion in mortgage bonds at the end of 2014. At a weighted average coupon of 4.5% (I made that up but it feels average-y at this point) that would generate about a billion dollars in interest per day. Factoring in principal repayments the US mortgage bond market has to attract more than a billion dollars every day just to stay the same size. ↩
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Ask an Ex-Banker: Home Loans and Home Equity Lines of Credit

Q. Dear Banker, My wife and I are planning an addition to our house. We need the additional space, but I do not want this project to stretch our overall budget. Since I have a specific idea of how much I want to pay, a rise in interest rates would cause us to make different decisions on the project details. Unfortunately, we need to make those decisions now but will not need the money for another 8-12 months. I don’t care if interest rates go down, I like where they are now, but borrowing money before you need it sounds foolish. How does your average Main Streeter hedge against interest rate swings?

Bradley T., San Antonio TX

 A. I understand your question to be whether you should borrow money now, before you need it, because rates are ‘low enough,’ and because you worry rates will not be this low in another 9 months when you actually need the money for the home renovation.

My short answer is: “Maybe, although I personally would not” as to whether you should borrow now and lock in today’s low fixed rates, in anticipation of needing money 9 months from now.  I’ll explain what I mean by that in a moment.  The longer answer, which I’ll detail more fully below that, is that you really need a home equity line of credit, not a fixed-rate home equity loan.

The Short Answer                                      

Should you lock in a loan 9 months early because rates are ‘low enough?’  I’ll make a bunch of assumptions to be able to answer the question specifically, and I hope you can adjust the answer to your own particular situation.

I’ll assume you can get a Prime[1] rate home equity loan for a pretty major $100,000 home renovation at 5%.  That means you’ll pay $5,000 per year in interest, or an extra $3,700 for borrowing 9 months early.

$3,700 is not the end of the world for peace of mind, and so I’ll answer “maybe” borrow this way to lock in an attractive low rate like 5% today.

There are a few reasons, however, why I would not borrow money early myself.  Foremost, we really have no idea which way interest rates will go in the future.

As a former bond guy,[2] I pay quite a bit of attention to interest rates.  Had you asked me at almost any time in the last 10 years whether interest rates were likely to go higher or lower in the next 18 months, I would have said ‘higher’ approximately nine out of ten years, and I would have been wrong approximately nine out of ten years.  That’s not because I’m ill-informed, it’s just because it’s much harder to forecast the future direction of interest rates than it seems.

Because of my own deep uncertainty about the future direction of interest rates, I would argue your choice to borrow 9 months early ‘locks-in’ a loan interest ‘loss’ of $3,700, whereas the rate available to you has a 50-50 chance of being higher or lower 9 months from now.  If you accept my view, then your interest cost for the next 9 months, by not borrowing, is $0, which is much more attractive than losing a guaranteed $3,700.

But what if, 9 months from now, your fixed rate jumps to 7% from today’s 5%, and you’re locking in a 10 year $100,000 loan at $7,000 a year, rather than the more attractive $5,000 a year interest cost?  Well, in that case, if you carry the full sized loan for 10 years, you’ll pay a total of $20,000 more in interest over the life of the loan.  In that stark (probably-worst-case-scenario) example you will have lost out, and you will curse my advice, as well as my children’s children.[3]

Given that the starting position of borrowing early is that you’re $3,700 poorer, however, I see many more scenarios in which you come out ahead by not borrowing early.

If you plan to pay down the loan principal faster than 10 years, for example, or rates shoot up less than 2% over 9 months, or rates stay the same, or rates go down even further, you will have broken even or ended up better off by not borrowing early.  So that’s why I wouldn’t take today’s rates.

The Longer Answer

Instead of a home equity loan locking in today’s good fixed rates, what you actually need is a home equity line of credit (HELOC) from which you can borrow money and pay down at any time.[4],[5]

When I started a business in 2004, I met with an elderly entrepreneur who gave me great advice: Obtain the largest possible home equity line I could, not because I needed it now, but, because as an entrepreneur I needed to be ready to take advantage of opportunities whenever and wherever they might arise.

He was right.  In fact, any person who is both a home owner and a business owner, needs to stop everything right now and start applying for a home equity line of credit.  Why are you still reading this blog post?  Go, do it, now.  I’ll wait.

Ok good, you’re back.  You’re welcome.

In your case, Bradley, the potentially higher rates one year from now will be more than made up by the fact that you can borrow only the amount you need, as you need it, for your home renovation.  The slower drawdown of debt principal and the faster payoff of principal via a home equity line of credit is virtually certain to save you interest costs in the long run.

I believe the fact that HELOC rates are floating – they may go up or they may go down over time – are more than made up for by the variable amount of principal you can take out only as and when you need it.  Over the course of your planned home improvement project, if you borrow for example $33,000 for some period of time, rather than the full $100,000 loan, you’re obviously paying 1/3 of the interest costs than you would on the full amount, during the period of the smaller borrowing.  My point is that even if you end up with the same peak amount of borrowing, $100,000, you’re likely to have paid significantly less in interest in getting to that point.  Most of the time, those savings will outweigh the probability-weighted cost of higher future interest rates.

A special note for small business owners, new and old:  If you’re just starting out, the HELOC may be your only ticket to borrowing money cheaply and flexibly.  Banks only pretend to lend to small businesses, and they certainly do not lend to new small businesses, so it’s hardly worth trying that route.  Banks do lend, however, against houses and home equity, so you’ve got a shot there.

For experienced small business owners: You still need the largest home equity line of credit possible.  You never know when the commercial property right next to your office may become available, and when having $50,000 in ready cash is the difference between acquiring the real estate of your dreams and paying more to lease office space for the next 30 years.  If you have to go to your bank to apply to get the loan to buy the property next door, you’re too late.  You need the home equity line so that you can credibly represent to the sellers your ability to close the transaction within 1 week, in ‘cash.’  That is how the pros do it.[6]


[1][1] Meaning, you have excellent credit, at least above a 720 FICO.  The FICO people sell their scores from all three major credit rating agencies here for about $35.  It’s worth it to pull your score once in a while, so you can confirm you’re eligible for the best rates and there’s no weird activity on your credit reports.  Don’t let FICO trick you into paying $14/month.  That’s stupid.

[2] No, not the Daniel Craig type of Bond guy, much to my wife’s chagrin.

[3] Which is as good a segue as I can think of for repeating Jack Handey’s Deep Thought: “I believe in making the world safe for our children, but not our children’s children, because I don’t think children should be having sex.”

[4] This entire ‘Ask an Ex-Banker’ advice column today assumes you are a responsible borrower, and that debt incurred through a home equity line of credit will go toward productive home and business improvements and not be blown on subsidizing your unsustainable consumer-driven lifestyle.  In your case, Bradley, since you live in San Antonio, that means you can’t blow the whole line of credit on Alamo Lego miniatures and bad Tex-Mex food.   But since www.bankers-anonymous.com readers are, almost by definition, extremely responsible with debt, this hardly bears mentioning.

[5] Most HELOCs give you a drawdown period of, say, 10 years, followed by a payback period of another 10 or 20 years.

[6] While I’m very much in favor of HELOCs for small business owners, I need to acknowledge in the fine print here that things can and have gone wrong for small business owners putting their houses at risk.  Of course this would be terrible.  When you get a HELOC for your small business, make sure you save it for an opportunistic can’t lose situation, not use it to keep your flailing, unsustainable, small business alive.

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