Home equity is back, baby! And, perhaps more importantly, consumers are beginning to take notice. After 13 consecutive quarters of year-over-year house price growth, according to the Federal Housing Finance Agency’s (FHFA) house price index (HPI), and with the Great Recession squarely in the rear view mirror, borrowers are more frequently tapping into their equity through cash-out refinances or home equity loans. According to the Freddie Mac Refinance Report, in the second quarter of 2015 refinances that resulted in a higher loan amount, or cash out refinances, made up 34 percent of all refinance origination volume, up a considerable 12 percentage points from the year prior. This resulted in an estimated $11.4 billion in total equity cashed out in Q2 2015, a sharp increase from the $5.7 billion in total equity cashed out in Q2 2014. This trend can be seen in closed-end home equity loans and open-end home equity lines of credit (HELOCs) as well. According to Experian, approximately $54 billion in new HELOC lines were originated in the first half of 2015, compared to $35 billion for the same period in 2014. Home equity loans also experienced a 22.4 percent jump in new originations during the first half of 2015 to 280,700 loans.
"Demand for housing will remain, but demand for home improvement may play a larger role in the market."
The rise in home equity lending has not only been buoyed by increasing house prices, but also comes alongside a constrained supply of homes for sale and historically low interest rates. The rising number of homes sold is helping drive demand for equity mortgage products, as recent homebuyers tend to spend in a burst on home improvements and frequently leverage home equity lines of credit to do so. On the flip side, for homeowners that have equity, drawing on their equity to remodel at low rates becomes an attractive option compared to trying to find the right move-up home in a tight market with limited inventory and high transaction costs.
This latter homeowner is faced with the decision to access their equity via a cash-out refinance, home equity loan, or a HELOC, a decision that is not necessarily a simple one to make. Take for example, a borrower with a primary residence valued at $500,000 and a 30-year fixed-rate loan originated with a balance of $350,000 at an interest rate of 4.125 percent with a monthly principal and interest payment of $1,696 who wishes to withdraw $50,000 of equity for home improvements. He could take out a home equity loan with a fixed interest rate over a 30-year term, however the interest rate on home equity loans, currently around 6.5 percent for a 30-year term or an additional monthly payment of $315, tend to be much greater than a HELOC or cash-out refinance and are probably not the best option for this situation. A cash-out refinance, where the borrower received a new 30-year fixed mortgage totaling $400,000 (the existing $350,000 balance plus the additional $50,000) at an interest of 4.125 percent would have a new monthly payment of $1,939 or roughly $243 more than the current principal and interest payment. Finally, a HELOC with an available credit of $50,000 at a 4.35 percent interest rate with an initial 10-year draw period would be an additional $181 a month, $62 less than the cash-out refinance when added to the original monthly primary mortgage payment and comes with limited closing costs. However, the HELOC comes with a variable interest rate and an increased payment at the end of 10 years when the borrower is forced to start paying back both interest and principal.
While saving $62 dollars a month, or $744 a year, may or may not be enough to convince a homeowner to take on the extra risk of a variable rate mortgage product, this calculation will change as mortgage rates begin to rise following the anticipated Federal Reserve rate hike later this year or early in 2016. A mortgage rate rise of one percentage point would change the monthly payment on the cash-out refinance in our example to $2,178, or $482 more than the original $1,696 monthly payment. The HELOC with a 5.35 percent rate would have a monthly payment of $213, costing the homeowner $269 a month less than the cash-out refinance option when added to the original monthly primary mortgage payment. Essentially, the anticipated rise in rates will have the effect of “locking out” borrowers from the cash-out refinance market and will only further increase demand for HELOCs. The more rates rise, the more pronounced the lock-out effect will be.
This lock-out effect may also spill over into the purchase markets as homeowners may become more hesitant to relinquish their current mortgage with a record low interest rate. Why would a homeowner buy a house with a $350,000 mortgage at 5 percent when they currently have a $350,000 mortgage at 4 percent? There is a strong incentive to remain in the existing home and make home improvements, again increasing demand in the HELOC market. While the fear is that higher interest rates will lower demand for existing homes; that may not be the entire story. As we noted last month, rising rates don’t necessarily trigger a decrease in demand. Demand for housing will remain, but demand for home improvement may play a larger role in the market.
