Avoiding the Pain of Home Equity Loans

It's amazing what a little uptick in interest rates and a slow-moving housing market will do to consumer behavior. Back when rates were low, people couldn't tap their equity fast enough. Now, with rates hovering around 8 percent and home sales dragging, borrowers are singing a different tune.

Where once upon a recent time there was a stampede of home equity borrowers bombarding lending institutions, now there's just a crawl. Home equity borrowing, which averaged annual growth over 20 percent for the past five years, has recently slowed to just 9 percent.

Several factors in the real estate market have caused borrowers to put on the brakes. When home values were constantly climbing, and low rates made money dirt cheap, people tapped equity without a second thought. But rates have steadily climbed over the past few years, and this increase has caused minimum payments on balances to swell, prompting borrowers to tighten their purse strings.

The amount of equity available for a homeowner to borrow has also contracted. Home values have deflated with the slowdown in the market. As a result, borrowers may find that if they tap too much equity, their home's loan-to-value ratio may push over 80 percent, triggering the need for private mortgage insurance.

HELOCs at the back of the line

The rate increases have caused borrowers to grow increasingly skittish about home equity lines of credit (HELOCs). The Federal Reserve's increase in short-term interest rates during the last several years has resulted in rates on HELOCs rising from lows of 4.6 percent in 2004, to well in excess of 8 percent in today's market.

Since fixed-rate home equity loans have lower rates than variable HELOCs, many borrowers are converting their loans to the more affordable option. Some homeowners are also opting for a cash-out refinance on their first mortgage, although this may lead to higher payments for a longer term.

New products, new promotions

In the scramble to adapt to the changing marketplace, lenders are rolling out new marketing strategies and home equity products. Campaigns include joint promotions with retailers, such as home improvement stores, in which discounts on supplies are offered as part of the loan package. Other lenders are simply beefing up their advertising and internal sales tactics to persuade more homeowners to borrow.

The home equity loan is morphing, as well. Many lenders are now offering a hybrid home equity loan, in which part of the balance has a fixed interest rate, with a line of credit tacked on for future use.

The slowdown in the home equity market is a reality check for lenders and borrowers alike. When home values were escalating and interest rates plunging, there was a flurry of irrational exuberance that simply escaped logic. The recent drop in the number of new home equity loans indicates not only a market correction, but also a return to economic reality.