TLDR; Home equity loans are better served avoiding or reducing consumer debt, not the opposite. Don’t wait until your credit scores or income prevents you from resolving your financial situation. Here’s how.
A cautionary tale
Admittedly, not a favorite story to share as it starts off with our characters scourging for means to face the mounting consumer debt combated with rising monthly costs, and this story is real.
Too many folks are operating in our economy using their survivor brain vs their prosperity mindset and it’s getting more messy.
In the last several months, the majority of inquiries for mortgage help have been from borrowers needing to tap their real-estate equity.
Let’s talk about the finer details of navigating home equity loans and why you might not want to wait to take action.
Economic eddies
While financial pundits have been talking about economic downturns for over a year and the economy continues to do its thing; our economy continues to plug along in “wait” mode.
Admittedly, I’m fascinated by the American consumer’s ability to spend money and inflationary pressure on housing and energy costs. Here’s an interesting synopsis of the situation…
“Headwinds ranging from low household savings and rising credit-card delinquency rates to the lagged effect of higher interest rates on credit-sensitive sectors of the economy will cause growth to lose momentum more noticeably after midyear. Once markets gain more clarity on the future path of inflation and interest rates, we anticipate opportunities to dial up risk in portfolios.” – Wells Fargo Investment Institute
This week’s inflation report was yet another piece of the puzzle and a signal any pre-election rate cuts are starting to dim. Worst case scenario, continued consumption levels persist fueling inflation and we could potentially see another rate hike; but hey, it’s an election year so chaos and confusion are abundant.
Borrowing against your home equity common use cases
Lately, a good number of requests from borrowers has been around debt consolidation; especially from both homeowners and investors. This is one of the more typical scenarios for home-equity loans. Here are a few of my most encouraging reasons to pursue a home equity loan:
- Minimizing interest fees – This is probably the biggest reason borrowers take out a HELOC/HELOAN. Minimum monthly payments and/or the ability to pay down debt become overwhelming
- Opportunity – Home equity is literally “house money” generated by home appreciation and it’s there to leverage as needed. Using equity in a piece of owned real-estate creates opportunities to buy more real estate or invest in other endeavors. The key word there is “invest”. (Most commercial real estate loans look for 20% down payments)
- Cover unexpected rehab/repair and living expenses – Need a new roof? Want a new kitchen? Sewer line backed up? You get the point.
Today’s risk of debt danger
I can’t stress enough how consumer debt companies do not care about how much debt you rack up so long as you pay the bills. This is a debt behavior completely at odds with mortgage lenders who care intrinsically about your debt-to-income (DTI) ratio.
Once you float beyond the 45%-50% DTI, chances of using your home’s equity as a bail out mechanism all but dry up leaving you with monthly consumer debt payments and an inaccessible equity in your real estate to bail you out.
There are three major breakpoints in how lenders evaluate credit scores; scores that fall below 780, 720 and 680. If your score drops below any of these breakpoints, the costs of borrowing and amount of equity you can leverage decreases.
Qualifying for home-equity loans
Home equity loans (i.e. HELOCs/HELOANs) are consumer-oriented products, not investment products. However, you can take out a home-equity loan on an investment property.
These types of mortgages use your adjusted gross income to determine your ability to repay. This is unlike a commercial/investment loan which focuses on the cash flow (i.e. rental income) to determine viability.
This can create headaches for investors who want to use a home equity loan to cover expenses related to a rental property if your focus has been on minimizing income. Read that again.
Why? Because your debt-to-income (DTI) ratio needs to be within required ratios for underwriting to approve your loan. Think a maximum debt to income ratio of between 43%-50%
The finer talking points of home-equity loans
Here are some helpful tips and data points to understand when considering a home equity loan:
- You need to know your debt-to-income ratio – A professional mortgage broker/lender will calculate this for you. If you want to do it on your own, add up all your monthly debt/legal/mortgage obligations and divide by .43, .45 and .50 to get the minimum monthly income you’ll need to qualify for a home equity loan at 43%, 45% or 50%, respectively.
- Avoid getting backed into the consumer debt corner – This means letting your credit score deteriorate AND your DTI to rise above 43% because the lower your credit score, the lower your access to leverage. Most home-equity lenders don’t entertain this situation leaving borrowers backed into a corner with more difficult choices.
- How much equity you can leverage – Home equity loans (HELOC/HELOAN) products typically offer borrowers the opportunity to leverage between 75%-85% of your property’ equity. In some cases, up to 90% of their home equity is allowed, but this is an exception.
- Understanding cumulative loan-to-value ratio (CLTV) – This ratio determines whether the amount your request to borrow will work with a lender’s HELOC/HELOAN program. If you have a first mortgage, you must consider this as part of your cumulative loan to value ratio (see above point)
- Using a home-equity loan to pay off debt at closing – It is possible to qualify for a HELOC/HELOAN by paying off debt at closing. This can help make your DTI ratios fit the underwriting model.
- Home equity loans are not free – These are real-estate loans that come with closing costs so be prepared to commit some of the equity you want to pull out of your real estate to these costs.
The good news is that you don’t have to have money to close as these feeds can be automatically paid at closing using your HELOC/HELOAN - Know how your monthly payment will be calculated – Not all HELOC programs are created equal and you’ll want to pay particular attention to how monthly payments are calculated/loan is amortized/recast. The most common type of HELOC offers a draw period and a payback period. During the draw period, you can withdraw from your line of credit and only make interest payments on the amount you’ve withdrawn.
- Know what draw period is being offered (i.e. 3, 5, 7 or 10 years) – A draw period is the period you have to use the credit provided in your HELOC. Once your draw period elapses, your outstanding balance is amortized over the remaining life of the loan. Most HELOC programs are amortized over 20-30 years. For example, if you have a 30-year HELOC and your draw period is 10 years, then the outstanding balance would be amortized over the remaining 20 years.
- How long does it take to close – HELOC/HELOAN Processing/underwriting timelines can range from a week to 45 days depending on the lender. Some lenders can fast-track your closing in less than a week.
- Types of property you can leverage – Today you can find home equity lenders who will allow you to borrow on your primary, secondary or investment properties. Keep in mind that the percentage of equity you can borrow against will be based on the property type. Commonly, investment properties are capped at lower loan-to-value (LTV)/cumulative-loan-to-value (CLTV) ratios than a primary residence.
- What are the recurring costs (i.e. annual fees) – Please ask your lender about recurring costs such as annual fees. Some lenders charge a nominal annual fee (i.e. $100)
- What are the closing fees – Taking out a home equity loan is not like a credit card. It’s a mortgage loan with closing costs that can include appraisal, credit report, origination, processing and underwriting fees.
- Type of required appraisals – The lender-required appraisal on your property will often depend on the amount of your home equity loan. For lower lines of credit, lenders may only require an electronic appraisal (i.e. MVR) while larger lines will require a traditional appraisal. Appraisal costs are typically incurred at the borrower’s expense.
- Minimum initial draws – Some modern HELOC programs require full or partial draws at the time of closing and do not allow repayment for up to 90 days. Others allow you to pay back immediately. Keep in mind, lenders lend money to generate revenue. They want you to pay interest on the interest on your outstanding balance so not surprising they want us to actually use the credit they’re providing.
- Loan type (HELOC vs HELOAN) – Essentially, a HELOC is a line of credit used as needed and a HELOAN is a lump sum delivered at/near closing. HELOANs can be had with a fixed interest rate, while HELOCs typically have a variable interest rate (prime + margin).
If you need help, get help
For the characters in our story, they were unable to qualify and are not seeking more drastic measures of liquidating personal property and real estate to right their ship. Unfortunately, this will slow their wealth generation efforts in the short term. However, beyond the horizon this gives them a better chance to prosper.
Waiting to prepare/deal with deteriorating cash flow in your life can often only make the situation worse. If you need to right your financial ship, home equity loans can serve an important purpose, IF you don’t wait too long to address the underlying situation (aka debt).
Home equity loans are better served avoiding or reducing consumer debt, not the opposite. Don’t wait until your credit scores or income prevents you from resolving your financial situation. Take advantage of your home or investment property’s equity to increase your chances of better financial prosperity in the future.
The best step you can take today is talking to an expert mortgage broker who can pre qualify you. It’s complementary and won’t impact your credit score but it will improve your ability to take action when the right property comes on the market.
Until next time.
All my best,
Bryan
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Bryan Kreitz
Mortgage Loan Originator NMLS 2267669
Bryan Kreitz, a seasoned mortgage consultant and the driving force behind Highlands Ranch Mortgage, brings an extensive background in real-estate financing and personalized lending solutions.
His expertise spans traditional and innovative loan options for a diverse clientele, including self-employed individuals and real-estate investors. Bryan’s dedication to client success in the mortgage industry is supported by his professional achievements and commitment to personalized service.
For the most accurate and detailed information about Bryan Kreitz’s professional background and expertise, visiting his LinkedIn profile and his About Highlands Ranch Mortgage page is recommended
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