After Tax Reform, Are HELOCs Dead?

Posted on by Phil Querin

“Reports Of My Death Have Been Greatly Exaggerated” ~Mark Twain (1835 – 1910)

History Revisited. Remember when the Home Equity Line of Credit (aka “HELOC”) was used as an ATM?  Need money for a remodel, new car, kid’s college education, debt consolidation, etc? No problem!  Your bank or mortgage broker was more than willing to give you one, along with a shiny credit card to draw down the available funds. All you needed was equity in your home, that is, the money represented by the difference between its current value and the total mortgage indebtedness against it.

These funds were viewed by some as being “trapped” in their homes, unreachable unless they refinanced their existing loan for more than the total mortgage[1] debt, and pulled out the extra funds. This was called a “cash-out” refinance, and occurred with some frequency in the years leading up to the Great Recession. But it was not nearly as convenient as using a HELOC.  And back in those days of “easy money” anyone who either purchased a home, or refinanced one through a bank, frequently got an extra HELOC loan, even if they didn’t ask for it. It was neatly planted behind the first mortgage, i.e. in a “second position”, and quietly waited for the homeowner to tap it. Payments were usually as little as interest-only, and since the interest was tax deductible, it proved as irresistible to homeowners as the sirens were to Ulysses.

Thus, with HELOCs, borrowers had a guaranteed reserve of available cash to use at will, whenever they wanted. They were viewed as a nice insurance policy to have, if necessary, without one needing to apply for a permanent loan, with its fixed amortization and fixed monthly payments of principal and interest.  The tax law generally permitted the first $100,000 of interest to be deductible.[2]  So, the roulette wheel just kept spinning….

During the years leading up to the Great Recession, HELOCs were ubiquitous, used even by those who had nearly paid off their first mortgage. They were used to get by between jobs, or due to divorce, illness, or other vagaries of life, and provided quick and easy access. In some instances, HELOCs carried balances in excess of the borrower’s first mortgage.

Then the Great Recession hit in 2007/8.  Banks had the first clue of a downturn, for reasons that need not be delved into right now. Suffice it to say that they realized the bundles of loans they were packaging and selling into what was known as the “secondary mortgage market” were not performing well, and investors had begun to shy away.  Without large institutional buyers for these packages of loans, the funds necessary to continue making more loans began to dry up. The Big Banks became victims of their own Ponzi Scheme, as they watched everything collapse in 2007 and 2008, like a house of cards.

And when the banks took precautionary action, it was quick and painfully efficient. In some cases, using nothing more than zip codes, lenders froze HELOCs withdrawals en masse – no more easy money. Why? Because lenders suddenly had an epiphany – they realized the impossible had become possible – real estate could actually lose value! Until that wake-up call, the entire country, its economists, financial institutions, the Fed, and every other sentient being all the way up to Alan Greenspan, believed that real estate prices only did one thing – they always went up, and never went down.

Lending money secured by one’s home had always been considered a safe bet; if the borrower defaulted, the home could be foreclosed, and the bank recovered its money. And borrowers placed a similar bet; if they suffered a reversal of fortune, they could always sell the home, pay off the loan (including the HELOC), and walk away with cash to boot.

But once the Recession hit, borrower financing dried up, and several things occurred in rapid succession:

  • Banks stopped making loans to borrowers with sketchy credit;
  • They began requiring thorough credit checks of prospective borrowers – no more “no-doc” loans;
  • Appraisers were forced to become more realistic about values – and they no longer routinely appraised homes at their inflated purchase prices;
  • The moment buyers had difficulty qualifying for loans, and properties had difficulty appraising out, sellers found it harder and harder to sell their homes at the listing price;
  • Ultimately sellers began to reduce their prices which invited lower and lower offers; and
  • Each time the sale price of a home decreased, it became a “comp” or “comparable” to be used by appraisers to establish current value – so just as a rising tide raises all boats, a lowering tide sinks them.

Eventually, as sale prices declined, homeowner equity began to drain away like water from a leaky tub. Eventually, equity disappeared, and values dropped below borrowers’ mortgage balances, resulting in what became known as “short sales”.

To make matters worse, the banks soon realized there was more bad news with their HELOC loans; they were “subordinate” in priority behind the first mortgages that their HELOC borrowers already had. This meant that in the event of a foreclosure by the first lender, it got paid before the HELOC lender saw anything. And if there wasn’t enough money to pay the first lender, the second, i.e. the holder of the HELOC, got nothing.[3]

The situation got so severe that HELOC lenders[4] and the holders of standard fixed-rate second mortgages saw their paper depreciate 90% or more. In some cases, lenders, usually as a part of a settlement with federal and state regulatory agencies, forgave the entire debt due under their HELOCs and second mortgages, since the homes they secured had no equity to attach to. This thin air soon became known by the oxymoronic term, “negative equity”.

Problem was, when crunch time occurred in the Portland area, which was around September, 2007, home values continued their downward spiral for almost exactly five full years. No more “easy money”. No more “no-doc”, “liar” or “Alt A” loans. And when homeowners sought to refinance their existing loans during this time, they found that either they couldn’t pass the credit screening, or that the home’s now-reduced value was already less than its total mortgage debt.  Refinancing was out of the question. And so things continued until 3Q 2012 in the Portland Metro area, when, after five years, home prices slowly began to struggle back.

Enter The 2017 Tax Reform Bill.  While there is much to say about this entire bill, the purpose of this article is to address its impact on HELOCs.  Although there are some who believe the interest deduction on HELOCs is gone, this is not entirely correct. Actually, HELOCs in 2018 and beyond[5] are alive and well – although some lender websites have not been updated to correctly define what can and cannot be deducted.

HELOCS in 2018 and Beyond. Historically, there were two types of permissible interest one could deduct on a “qualified residence”[6]: Acquisition Debt and Home Equity Debt.

  • Acquisition Debt was defined as that which was used buy, build, or substantially improve one’s primary residence, or an additional personal residence;
  • Home Equity Debt was debt (other than acquisition debt) that was also secured by a qualified residence and could be used for any purpose without limiting the deductibility of the interest.[7]

Deductible mortgage interest on a qualified residence was permissible:

  • On a mortgage of up to $1 million of acquisition debt; and
  • On up to $100,000 of home equity debt.

Under the new tax reform law, beginning in 2018, interest on home equity debt, e.g. HELOCs, will not be permitted for just any purpose. But since the technical definition of “acquisition debt” includes any loan to buy, build, or substantially improve a qualified residence, a HELOC can be used, for example, to remodel one’s home.  In all other respects, i.e. the $1 Million dollar cap on purchase price and $100,000 cap on home equity debt, remains unchanged.

So, for example, if a taxpayer today borrowed $100,000 secured by a HELOC, using $25,000 for their child’s education, and $75,000 to add a bedroom onto their home, interest on the $25,000 would not be deductible, but interest on the $75,000 addition would be.

Unfortunately, however, the limitation on HELOC interest is not retroactive. So for taxpayers who currently have HELOCs that were not related to the purchase, construction, or remodeling of a qualified residence, they will no longer get to itemize the interest deduction. The loss of this non-qualifying deduction may incentivize some taxpayers to pay off their HELOCs sooner than planned.

HELOCs Generally.  Compliments of Evan Swanson, Swanson Home Loans, with whom I consulted in researching HELOCs, here is some interesting information on their use today:

Here are the industry “averages” for HELOC terms:

  • They are typically for a 25-30 year term;
    • The initial ten years of the loan is the “draw period” where consumers can pay interest-only, pay it down to zero, borrow it up to HELOC limit, or anything in between – e.g. much the same as a credit card;
    • At the end of 10-year draw period, the remaining principal balance on the HELOC will amortize over the remaining term of the loan, and the ability to draw on it goes away;
    • Rates are variable, often based on the prime index (currently 3.75%) which increased by .75% in 2017, in lock-step with the three separate Fed rate hikes of .25% each.
  • HELOCs are widely available for up to 80% of a home’s value (after deducting the principal balance due on the first mortgage), and in some cases even a 90% loan-to-value can be arranged.
  • Typically, there are little or no upfront costs, with a $75 annual management fee, $500 prepayment penalty if they are paid off and closed within first 3 years.

Conclusion. Were HELOCs abused during the lead-up to the Great Recession? Not in my opinion. They were used for precisely the purpose intended, i.e. when the need arose. Sometimes borrowers used the funds to purchase other property; sometimes to buy a boat; and other times to remodel their home.  It was all fair game.  Was it risky? Yes, but only in hindsight, since we now know that real estate values can go down.  But during the pre-recession era, the calculus – not unreasonably – was that the only real cost ofa HELOC was the monthly deductible interest payment.  At some point, when the value of the home appreciated sufficiently, the HELOC borrower would either sell the home or refinance it, paying off the first mortgage and the HELOC, with equity to spare.

Today, borrowers and homeowners have either been chastened, or not having reached adulthood ten or more years ago, have heard the cautionary tales. Risky HELOC borrowing is not really a part of most borrowers’ mindset today.  But no matter, the new tax reform law has taken away the major incentive for using HELOCs frivolously, i.e. deductible interest. But for some, just having the HELOC, even if it’s not used, may provide some measure of comfort in having a safety net, just in case.

So in answer to the question, “After Tax Reform, Are HELOCs Dead?” the answer is “No”, they are alive and well. ~Phil

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[1] Technically, when a residential loan is made in Oregon and most other states, a “trust deed” is used to secure the repayment obligation memorialized by the promissory note. However, since most folks know what a “mortgage” is, and are not as familiar with the term “trust deed”, I will use the former term interchangeably. The only real difference between the two instruments is how they are foreclosed.

[2] I say “generally”, because if a buyer used a second mortgage or a HELOC to finance the acquisition of a home, the right to deduct all of the combined mortgage interest applied only to homes up to $1 million for joint filers, or $500,000 for single filers.

[3] In an interesting turnabout, struggleing homeowners always tried to pay their first mortgages, since those were the biggest, and they were the ones most likely to foreclose if not paid. But the holders of second mortgages or HELOCs didn’t have the same ability to foreclose, because they were “subordinate”. If they were to foreclose for nonpayment of their second mortgages, it meant that the first mortgage would be undisturbed, and following the foreclosure by the second-position lender, it would get the property back and have to service, or pay off, the first mortgage debt themselves.

[4] Interestingly, since HELOCs carried a higher rate of interest, while lenders sold off their first mortgages into the secondary market, they kept the HELOCs, because of the higher yields. That approach only worked as long as (a) there was sufficient equity in the home to cover the HELOC debt, and (b) the homeowner would continue to pay the HELOC. When borrowers started to see their home equity would not support both a first and second loan, interest in paying the HELOC waned.

[5] At least until December 31, 2025, when the entire tax reform law is scheduled to sunset.

[6] A “qualified residence” includes the taxpayer’s primary residence and one additional personal residence.

[7] The only limitation relates to those subject to the AMT or “Alternative Minimum Tax”. Those taxpayers could only deduct mortgage interest on a qualified residence for acquisition debt – but not home equity debt.

 

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