Home equity loans and home equity lines of credit, or HELOCs, are popular avenues for borrowers looking for large upfront sums of cash with better interest rates than are available on unsecured personal lending products, such as credit cards and personal loans.
In either case, a home equity loan or HELOC can help borrowers deal with an unexpected immediate expense, such as medical care, enhance the home with an addition, pay for college for the kids, or consolidate other consumer debt. For some clients, there are benefits to tapping their homes' equity, but advisors should be aware of situations where it is not in clients' best interest to borrow against their property.
When clients broach the subject of home equity loans or HELOCs to advisors, the advisor should be proactive in determining whether the client is a suitable candidate for taking on another monthly payment. This speaks to the life planning model
many advisors are embracing, meaning advisors should ask direct, specific questions regarding clients' intent for the home equity funds.
“If you need to update a kitchen that was last renovated in the 1970s, you can use the cash from a home equity loan to pay your contractor,” according to Quicken Loans
. “If you want to help your children cover their college tuition, you can use a home equity loan for this, too. If you have a specific project in mind, then, taking out a home equity loan might be one of the most affordable ways to fund it.”
Those would be example of scenarios where unlocking home equity would be appropriate for clients.
Running The Numbers
It's human nature to be enticed by upfront sums of capital without giving much thought to repayment terms and how another monthly bill can affect us. To that end, advisors must initiate numbers and planning conversations with clients mulling home equity options.
In a hypothetical example, an advisor in a high cost real estate region, say California, is likely to have plenty of clients living in homes valued in the $1 million range. Using that home value as the benchmark, the client would likely need to have equity of at least $300,000 in the property for most traditional lenders to entertain an equity loan.
Assuming the client put $200,000 down on the property at a 30-year fixed rate of 3.625 percent, their monthly home expense is in the area of $4,600, as indicated by the chart below.
Using a loan-to-value ratio of 80 percent with the above terms, many traditional lenders, would likely approve a HELOC for $100,000 or less as highlighted by the chart below from JPMorgan Chase.
For a borrower with excellent credit (780 and higher) a $100,000 equity loan at an APR of 6.05 percent means a payment of just over $500 per month, meaning the client would have total mortgage payments of around $5,100 a month.
Even for clients that don't carry mountains of consumer debt and that live within their means, devoting more than $60,000 annually in after-tax income to servicing mortgage debt may only be suitable for those in high income brackets.
It's up to advisors and clients to agree on what's “high income” because it can vary from region to region, but in California a single person grossing $250,000 per year will net nearly $159,000. Subtract the $60,000 in mortgage expenses in the aforementioned scenario and that earner is left with $99,000 to address everything else from car payments to food to entertainment and, of course, retirement planning.
Aside from the obvious issue of potentially strained finances by way of a second mortgage, there are other issues advisors need to address with clients considering this type of financing.
Notably, the passage of Tax Cuts and Jobs Act of 2017 altered the IRS treatment of home equity loans, meaning that borrowers can only deduct interest from these loans if the debt is procured to enhance the property. Getting a second mortgage to build a new patio or improve your master bedroom? You're in luck because you get the tax deduction, but if you're using the loan to pay off consumer debt or take a vacation, the tax break is not applicable.
While often preferred to standard home equity loans due to the faster approval process, HELOCs carry their own set of risks, too. HELOCs, like some credit cards, carry annual fees and the line can be frozen by the lender if the value of the property declines significantly.
Additionally, there's punishment for diligent borrowers that repay the used portion of the HELOC and don't use the line again for awhile because the lender can charge an inactivity fee. To top it all off, some creditors can levy prepayment or cancellation penalties on borrowers that pay their lines early.
Not all lenders address the fine print with borrowers and not each client wants to read the fine print, meaning advisors should take the lead in highlighting some of the vexatious costs and fees associated with borrowing against a house.
Related: How to Talk to Clients About Reverse Mortgages