Taking advantage of rising property values, record numbers of homeowners are turning to home equity loans as a source of easy cash.
Overall, home equity originations climbed 35 percent last year to a record $431.3 billion, according to SMR Research Corp., a market research firm in Hackettstown, N.J. Most of the growth has been in variable-rate lines of credit that are tied to the prime rate, currently 5.25 percent. Countrywide Financial Corp. originated $30.9 billion in home equity loans last year, a 71 percent increase. Wells Fargo & Co. said its equity volume jumped 45 percent last year.
An equity line of credit gives a homeowner the right to borrow up to a certain amount, all at once or as needed. Borrowers pay interest only on the amount withdrawn. Home equity loans provide borrowers with a lump sum and carry fixed rates.
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As competition heats up — and rising rates make refinancings less attractive — lenders are looking for new ways to boost this market. U.S. Bancorp recently tested a home equity line that rewards borrowers over time. Under the program, the rate on the credit line drops by 0.25 percentage point every six months during the first two years to a maximum of prime minus 1 percent. Borrowers can keep the lower rate if they hold onto the credit line when they move to a new home.
The rise in home equity lending may reflect a more fundamental shift in consumer borrowing habits. “Home equity lending is displacing other forms of consumer credit,” such as credit cards, mortgage insurance and first mortgages, Morgan Stanley analyst Kenneth Posner said in a recent report. Posner estimates that the home equity market could grow by as much as 20 percent per year through 2010. For borrowers, the advantages include lower rates and tax deductibility, but there are fears some homeowners may become overextended.
Credit card companies, which have seen growth slow, are taking notice. Capital One Financial Corp. began originating home equity loans in a partnership with Countrywide Financial in 2003. In December, it agreed to pay $155 million for eSmartloan, an online originator of home equity loans.
MBNA Corp. expects its home equity fundings to climb by more than 70 percent, to $2.4 billion this year. MBNA provides financial rewards to phone representatives who refer customers who call in with credit card questions to the company’s mortgage lending operation. It is also looking to offer home equity loans to affinity groups, such as doctors, says MBNA Vice Chairman Ric Struthers.
Rising home prices have helped fuel sales of home equity loans, in part by boosting the amount homeowners can tap. Also, many home buyers are opting for so-called “piggyback loans,” which combine a traditional mortgage for 80 percent of the purchase price with a home equity loan or line of credit — often because they don’t have enough funds for a down payment. Other homeowners, with small mortgage balances, are trading in a higher-cost traditional mortgage for a line of credit.
As the number of home equity loans has increased, so has the amount borrowed. The average size of a new home equity line climbed to nearly $78,000 last year, up from roughly $57,000 in 2001, according to Benchmark Consulting International in Atlanta. The Federal Deposit Insurance Corp. says home equity loans are the fastest-growing asset class on financial institutions’ balance sheets. Home equity loans and lines accounted for roughly 25 percent of the growth in mortgage debt in the third quarter of 2004, according to the Federal Reserve Board.
Some homeowners use home equity lines as a reserve fund to be tapped in an emergency. But utilization rates are increasing, with borrowers drawing down an average of nearly 51 percent of their credit line in October, up from 46 percent a year earlier, according to LoanPeformance, a San Francisco firm that tracks mortgages.
To boost usage, some lenders, such as Wells Fargo and U.S. Bancorp, reward loan officers if lines are tapped and kept open within preset periods. MBNA plans to roll out a credit card that will allow borrowers to earn reward points when they tap their home equity.
For borrowers, home equity lines look especially attractive when compared with alternatives such as credit cards. Some lenders offer lines with rates as low as one percentage point below prime, according to HSH Associates. Rates on credit cards, meanwhile, average 12.2 percent, according to Bankrate.com. Interest on the first $100,000 of a home equity line is typically tax deductible.
As with credit cards, the cost of a home equity line of credit goes up when the Federal Reserve Board raises short-term rates, which it has done five times since late June. The blow is softened, however, by the fact that loan balances tend to be relatively small. Someone who borrowed $50,000 using a 15-year home equity line would pay roughly $370 a month if rates were 4 percent, the prime rate before the recent series of increases. The monthly payment jumps to $402 with a 5.25 percent rate and to $449 at 7 percent, according to SMR Research.
As the Fed raises short-term rates, home equity lines have lost some of their edge over fixed-rate home equity loans, which have barely budged. The difference between loans and lines of credit now stands at just 1.37 percentage points, down from 2.37 points in June, according to HSH.
Whether a loan or line makes the most sense depends in part on whether you will need the money all at once or over time, and how much more you expect rates to rise in the future. If you think rates will rise significantly, a fixed-rate loan could be a better move. About one-quarter of Bank of America’s home equity customers are taking advantage of an option that lets them lock in the rate on part or all of their credit line.
Wells Fargo has seen average application volume for its SmartFit Home Equity Account triple since it began a national advertising campaign in October. The product lets borrowers fix the rate on the credit line for the first three, five or seven years.
The sharp rise in home equity lending has brought heightened concern from bank regulators. In a recent speech, Acting Comptroller of the Currency Julie L. Williams warned banks about lax home equity standards. The Office of the Comptroller of the Currency plans to issue guidance for lenders on how to manage the risk in home equity lending, she added.