Lead Story… One of the hallmarks of the housing bubble was mortgage equity withdrawal. The market was soaring and anyone with a pulse could get a mortgage with little to no money down and then watch their net worth grow (at least on paper). As this happened, home owners felt wealthier and wanted a way to spend their newfound treasure. Enter the home equity line of credit or HELOC. The product had been around for years but was taken to new extremes by lenders who were all too eager to originate new business and borrowers who succumbed to the wealth effect even as wages remained largely stagnant. It’s a self-perpetuating cycle up to a point: borrower extracts capital from home and spends it in the economy, economy grows which helps the housing market continue on it’s upward trajectory. Some lenders even lent at loan to value ratios above 100%! All was well so long as housing values continued to move higher. However, they didn’t and we all know that this story ended in over-leveraged tears and bank bailouts. Not surprisingly, mortgage equity withdrawal went massively negative during the ensuing crash, then rebounded but stayed in negative territory for quite some time as the HELOC spigot shut down completely and borrowers went through the painful deleveraging process. It was one hell of a party and the hangover lasted from 2008 all of the way through early 2016.
Today, values are up and mortgage equity withdrawal via HELOC is making a comeback, especially among younger home owners. CNBC’s Diana Olick reported on the trend earlier this week (emphasis mine):
Fast-rising home prices gave homeowners more equity than many expected, and they are now tapping that equity at the fastest rate in eight years.
Homeowners gained a collective $570 billion throughout 2016, bringing the number of homeowners with “tappable” equity up to 39.5 million, according to Black Knight Financial Services. Those borrowers have at least 20 percent equity in their homes.
But the fact that mortgage rates were lower last year makes it less likely today’s borrowers would want to refinance this year. About 68 percent of tappable equity belongs to borrowers with mortgage rates below today’s levels. The vast majority of these borrowers, more than three-quarters, also have FICO credit scores well above average, which gives them more options for cashing out on their homes.
Enter the HELOC. Home equity lines of credit are second loans taken outside the primary mortgage, and millennials are leading the pack to cash in.
“The last time interest rates rose as much as they have over the past few months, we saw cash-out refinances decline by 50 percent,” said Ben Graboske, executive vice president at Black Knight. He expects to see more HELOCs instead.
And more millennials are using HELOCs than Gen-Xers or baby boomers, according to a survey by TD Bank. In fact, more than a third of millennials said they are considering applying for a HELOC in the next 18 months, which is more than twice the rate as Gen-Xers and nine times that of baby boomers.
At first glance, the idea of home owners being more likely to take on floating rate debt like HELOCs while interest rares are increasing seems crazy but it isn’t . As stated above, borrowers generally aren’t going to refinance their existing mortgage and take cash out if today’s rates are higher than the loan that they already have. So, if a home owner wants access to cash in his or her home, it either means taking out a 2nd mortgage or a HELOC. The beauty of a HELOC is that the money is available but as a revolving line of credit that can be drawn on as needed as opposed to a traditional 2nd mortgage where the money comes out up front and can’t be re-drawn. Here’s where it gets interesting from Diana Olick (again, emphasis mine):
Home remodeling was the No. 1 reason for taking out a HELOC last year, according to TD Bank, with debt consolidation coming in second. The home remodeling industry has seen a huge boost in the last year, as home prices rise and the supply of homes for sale shrinks. Homeowners are finding it harder to find and afford a suitable move-up home, so they’re increasingly choosing to stay and remodel.
Millennials are entering the housing market more slowly than previous generations, and those who have in the past few years tended to buy cheaper fixer-uppers. In just a few years, however, they’ve gained enough equity from rising prices to be able to pull cash out and remodel. They are, however, still very conservative. Borrowers doing cash-out refinances last year still had close to 35 percent equity left in their home, the lowest on record, with an average credit score of 750, according to Black Knight. Borrowers are still using HELOCs at barely one-third the rate they did in 2005.
So, while HELOC issuance is up, the money is being spent on renovations to add value, not vacations, cars, etc. The fact that HELOC use is still 1/3 of what it was at the peak of the bubble and that borrower equity is high are positive signs as well. This story makes a lot of sense in light of the tight supply and rising values that characterize today’s housing market for the following reasons:
- Older home owners are not moving as frequently as they used to, due at least partially to balance sheet issues. These home owners are sitting on a massive portion of the move-up home stock.
- New home construction is still historically low, especially for this far along in the cycle, further suppressing available move-up inventory.
- Investors bought up a substantial number of starter homes in the wake of the crash and foreclosure crisis, reducing supply in that market segment.
- First time buyers who bought starter homes during the recovery are now sitting on large gains since they own an asset that has benefited from both a normalizing market and unusual scarcity. In previous cycles, they would sell and roll those profits into a move up home. However, they largely aren’t doing that since there are so few move up homes available and bidding can be fierce. What good is it to take a profit on your current house only to overpay for your next house and carry a higher tax basis?
- The answer is to take out a HELOC, tap into equity and renovate the house that they already own. When this is done in scale, entire neighborhoods can change. What was once an entry level neighborhood, now becomes a move up neighborhood because the character of the housing stock changes. As an aside, I’m seeing anecdotal evidence of this where I live that is full of houses built in the 1950s. My neighborhood is like a construction site but the housing stock has been upgraded substantially in the past 5 years and values have risen accordingly.
- If you want more evidence that this is happening in a large scale, take a look at the stock of Home Depot versus the XHB Builder Index. There is little doubt that we have been in a remodeling boom and not a housing boom despite the increase in housing prices.
Rising HELOC issuance and mortgage equity withdrawal for renovations are symptoms of a market where supply is constrained and also a cause due to the way that the money is being spent. The lack of move up supply is having a cascading effect on supply and resulting in removal of more traditional entry-level homes through large scale renovations in entire neighborhoods. This trend likely has some room to run given how high borrower equity currently is even if home price appreciation slows. That being said, if equity begins to fall substantially, it will be a red flag. A market that is reliant on ever-rising home values to prop up home equity withdrawal is not sustainable, as anyone who lived through the housing crash is all too aware.
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Chart of the Day
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