Home equity lines of credit (HELOCs) have lately been maligned with unsustainable mortgage equity withdrawal (MEW) financing such essentials as two-week long vacations, German-imported vehicles, requisite granite counter tops and travertine flooring; however, HELOCs are a useful and important financial vehicle available to home owners. Their importance escalates in times of tightening credit and stable/declining home values. In this three part series we examine some of the important features that home equity lines of credit offer to homeowners as part of a strategic home financing plan. We’ll examine the following three features in this series:
- Convertible HELOCs
- True no-cost HELOCs
- Equity protection & repositioning
Today, we’ll look at the important role that convertible home equity lines of credit can play in helping reduce monthly mortgage payments as well as protect against the payment shock so often associated with adjustable rate mortgages. If you are a luxury property owner or a Realtor who services the luxury market-be sure to read to the end for my Two Gems of Convertible HELOCs that are just for you.
Home Equity Lines of Credit BASICS
Before we get in to the important features we need to first cover some basic ground for those that are not entirely familiar with home equity lines of credit. A HELOC is a loan secured by your home that differs from a traditional home loan in the following ways:
- It is tied to the prime interest rate, which means the interest rate can fluctuate up and down as the prime rate changes. Prime is tied to the Fed Funds rate; which dictate the short-term interest rates available on debt such as HELOCs, credit cards, and other short-term debt.
- HELOCs are made up of two parts, the “line amount” which is the amount of money that you can borrow on the HELOC; and the “draw amount” which is the amount of money you initially borrow when you open the HELOC.
- You can withdraw money for a set period of time after opening the line (usually 10-15 years) at any point via a credit card or checks tied to your HELOC up to the approved line amount.
- You only pay interest on the amount borrowed, regardless of the line amount. With a traditional mortgage you begin paying interest on the entire amount right away.
- Your minimum monthly payments are initially calculated as interest only for the first ten years. This allows you to either pay down the line, or simply make the interest payments to keep the line in good standing.
- HELOCs are usually based on a 25 year repayment term. The first 10 years are interest only, the remaining 15 years principal and interest are owed to pay off the line.
- May be convertible to a fixed rate mortgage one or more times during the life of the loan term. A small fee may be charged to convert.
Home equity lines of credit are often used as an alternative to a second mortgage. In the industry we refer to them 2nd liens or being in “2nd position” to refer to their subordinate position to the primary “1st” mortgage. However, HELOCs can also be used in first position, as an alternative to first mortgage products.
Convertible Home Equity Lines of Credit
A convertible HELOC refers to a home equity line of credit product that can be converted from an adjustable rate HELOC in to a fixed-rate mortgage. While each bank offers a slightly different type of convertible product most have similar characteristics.
- Can convert from HELOC tied to the ever-adjusting prime interest rate to a fixed-rate mortgage (typically 30-year fixed).
- Can continue to use remaining credit available above and beyond the fixed amount.
- Done over the phone with a customer service representative, the conversion goes in to effect immediately.
- No additional qualifying is required. No underwriting, credit review or asset/income documentation needed.
- A small fee (~$250) may or may not be charged for the conversion.
- Multiple conversions may be allowed. Common conversion allowances are 1, 2, and 5 times.
- Conversion is to the prevailing fixed interest rate available through the bank (or some rate based on the prevailing rate + a premium for conversion).
Questions to Ask Before Committing to a Convertible HELOC
- Is there a charge for converting to a fixed-rate mortgage? What is that cost?
- Is there an ability to continue to use the remaining credit available on the line after a conversion?
- Is the conversion to a 30-year fixed term?
- Is the payment on the converted line interest only or principle and interest?
- How many times can I convert?
- How often can I convert?
Some Typical Uses of Convertible HELOCs
People use a convertible HELOC to complete a very specific project that may take time to accomplish. Consider a lengthy home improvement project. By taking a 2nd mortgage, you receive all the money from the financing immediately and begin paying interest on that amount from day one. This is not the most desirable outcome for a large-scale renovation or remodel. If you undertake a significant addition to your home you need time to go through the planning, permitting and specification phase of the project before building actually commences. This process often takes many months.
If you are planning on financing this upfront work with money from your home equity using a second mortgage would require you to pay interest on the full amount borrowed. With a HELOC you can draw little amounts at a time to pay for related expenses. Interest is only owed on the money borrowed.
In these types of situations a HELOC may save you money over the long run, as you are only charged interest on the money you borrow. However, once the project is complete and you anticipate no future withdrawals on your HELOC; converting to a fixed-rate allows you to keep your monthly payments fixed for the duration of the repayment period. This removes your exposure to jumps in the prime interest rate, and the concomitant increases in monthly payments.
People also convert their HELOCs in to a fixed-rate loan once they’ve used the balance of their home equity line. Similar to the end state of scenario 1, once the HELOC is tapped out it makes sense to protect yourself from the exposure of rising interest rates. Converting the HELOC to a fixed-rate loan accomplishes that nicely.
If interest rates begin to rise quickly and you have no current need for your equity line, converting to a fixed-rate loan can create dramatic monthly savings when compared to letting the interest rate float. This strategy makes sense usually under the following conditions:
- You have multiple conversions available on your line.
- You are able to continue to use the line after converting the currently-owed balance to a fixed-rate
If your line has these options, then converting the currently-owed balance to a fixed rate can provide you with stable monthly payments, while still maintaining access to your equity for future expenses.
Using the Convertible HELOC as a First Mortgage
Here is where convertible HELOCs get interesting; especially in a higher-rate environment like the one we are currently facing in the housing market. Let?s take the specific example of a home owner who maintains a property worth $1,000,000; a common scenario along the California coast. If they purchased the home within the last five years, or have refinanced in the last five years, they more-than-likely hold some type of jumbo, Alt-A 1st mortgage (or 1st and 2nd combo). Jumbo mortgages are anything over $417,000, the conforming limits for Fannie Mae and Freddie Mac purchase. Alt-A mortgages had low rates and loose qualifying guidelines during the past five years, making it easy for people owning expensive properties to find inexpensive financing. The mortgage market has changed dramatically in the last few months.
The current mortgage market for jumbo and Alt-A loans has been priced with a much higher premium to interest rate lately as the secondary mortgage market has balked at high-balance home loans. A jumbo loan in 2005 that was 6% is now 8% – a huge increase when considering the large loan amounts associated with high-end properties. On a million-dollar loan this change represents a 23% increase to the monthly payment. This has effectively locked high-end property owners out of the refinance or purchase markets.
It is especially painful to jumbo loan holders who are also in adjustable rate mortgages (ARMs) coming in to their adjustment period. Many Alt-A loans were mid-term ARMs with 3, 5 and 7 year terms. These loans face pricey payment adjustment schedules which can make a once affordable mortgage quickly unaffordable.
Here is where our friend the convertible HELOC comes in to play. Home owners facing the specter of an ARM reset in a jumbo loan can use the convertible HELOC in two ways to help reduce their mortgage payments. I call these the Two Gems of Convertible HELOCs.
Take the HELOC in first position as a 1st mortgage. Some convertible HELOCs convert to a much lower interest rate than their 1st mortgage jumbo competitors. Ask your mortgage professional what the going rate is on the converted loan and you may be surprised to find that it is nearly a full point lower than the going jumbo interest rate on the same loan. Continuing our $1,000,000 loan example from above; this 1% interest rate difference results in a 9% monthly payment savings. This savings can be the difference between affordable mortgage option and unaffordable mortgage option.
The reason this exists is that some HELOCs convert to the going 30-year fixed rate, regardless of other factors. Now this type of program is not available at every bank, if you can find a bank that does-you now have a viable jumbo loan alternative to the pricey 1st mortgage products available today.
This does carry some caveats. You must understand the conversion options, the rate that you?d be converting to, and any other limitations prior to signing on for the HELOC. Some banks make their conversions overly expensive to keep this type of financing from cannibalizing their jumbo loan financing pipeline. You also need to understand that you may have to carry the higher interest rate of the HELOC for a period of up to a week after signing loan documents. This requires that you have a very trusting relationship with the mortgage professional you work with; and that you verify all aspects of the HELOC documents carefully to ensure your conversion options match what you discussed during the loan process.
Instead of taking the whole loan balance as a 1st position HELOC, take a conforming 1st mortgage up to $417,000 and then take the remaining as a convertible HELOC. Once you sign the loan documents you can convert the HELOC to a fixed rate and achieve a blended interest rate (the effective interest rate of your 1st and 2nd mortgage combined) that can also be up to a point lower than the going jumbo loan rate.
In order to calculate the blended rate of the two mortgages use the following equations:
(1st Mortgage / Total Mortgage Amount) x 1st mortgage interest rate = Rate 1
(2nd Mortgage / Total Mortgage Amount) x 2nd mortgage interest rate = Rate 2
Rate 1 + Rate 2 = Blended Rate
1st Mortgage: $417,000
2nd Mortgage: $583,000
1st Mortgage rate: 6.5%
2nd Mortgage rate (after conversion): 8.5%
(417,000 / 1,000,000) x 6.5 = 2.71%
(583,000 / 1,000,000) x 8.5 = 4.96%
Blended rate: 7.67%
The convertible HELOC is an important financial tool for any homeowner; especially homeowners who are in jumbo loan products. As detailed in the example above a convertible HELOC can provide an avenue of lower-cost financing than the current Alt-A and jumbo loan markets currently offer. There are some definite caveats so it is important that you speak with a mortgage professional who can expertly match your current financing needs with the best combination of products available on the market today.
Contact my team to learn more about how jumbo loan financing can still be affordable using a convertible home equity line of credit.