Adolfo Cabral and Dorothy Cox bought their Berkeley home in 2000, and now, after economizing and making extra payments when possible, “we have quite a bit of equity,” Cox said.
The two are not alone. Many homeowners in Berkeley and the Bay Area find themselves with impressive amounts of equity, meaning the difference between what they owe on the home and what it would sell for. Experts caution, however, that tapping home equity is something a homeowner should approach carefully.
Sean Kenmore, a certified financial planner and founder of Affinity Capital Advisors in Berkeley, advises his clients touse other sources of capital available to them prior to using an equity line of credit or refinancing their mortgage.
“In that expansionary period of 2003-2007, a lot of people were in the mindset, ‘I can spend whatever I want and the market will keep improving; in the worst case I’ll sell my home,’ but then the market went down and their homes were underwater,” in many cases leading to short sales or foreclosure, Kenmore said.
“I hope people don’t have short-term memory loss and get in the habit of spending like the federal government and having a deficit,” the planner said. Like all the experts we spoke to for this article, Kenmore noted that circumstances vary for different people and none of his comments should be taken as advice for any given individual.
“The reason people have a lot of equity in their homes right now is because of this completely unreasonable real estate market we have now, where prices are appreciating at 10% a year, there’s a lack of inventory and too many buyers,” said Vic Joshi, an Oakland mortgage lender with C2 Financial Corp. with 20 years of experience.
“Low inventory” refers to the fact that there is a dearth of homes on the market, a condition that has existed for at least four years.
“Prices are now greater than they were in 2007 before the real estate markets collapsed,” Joshi said. Home prices have come roaring back in the approximately five years since the market turned, with the median price of a Berkeley home around $1 million.
In many cases, this means homeowners have hundreds of thousands of dollars’ worth of equity, and the temptation to use the money can be strong. However, there are pitfalls.
There are several ways to tap home equity, including selling the house or taking out a reverse mortgage. Probably the most common approaches are setting up a home equity line of credit or refinancing the mortgage and taking some of the equity — a “cash-out refi.”
Home equity lines of credit – also known as HELOCs – became popular during 2003-2007, the years of what then-Federal Reserve Head Alan Greenspan called “irrational exuberance.” They are essentially second mortgages, something that seemed to be universally ignored during that period.
Unlike credit card debt, which is unsecured, a home equity line loan is secured by the home. The borrower can take out a loan for less than the entire amount of equity.
While these details are understood by many, something that has escaped notice was that the interest rate is variable — a Catch-22 that tripped up many, leading to short sales or foreclosures.
The interest rate is based on what’s known as the prime rate, an index used by banks to set rates.
When the prime rate increases, the person who holds the loan will have to pay higher interest on the loan and thus will have to make higher monthly payments. Interest rates in the U.S. have been creeping up, albeit slowly, since 2015. If the loan holder can’t afford the higher payments, he or she could lose the home.
The variable rate can change to where you can’t afford it
The variable rate “could change to where you can’t afford it,” and a home equity line may involve an annual fee, said Jill Hollander, a principal at Financial Connections Group in Corte Madera.
“It all goes to the question, ‘Why do you want a home equity loan?’ If you need it to live on, then perhaps you need to be looking at whether there are other avenues for you to trim your expenses,” Hollander said.
In contrast to a home equity line, with a cash-out refinance, “you may be able to take out a 30-year mortgage and your payments would be fixed for the duration and you would be paying back principal and interest,” Joshi said.
Refinancing means the homeowner has reset his or her mortgage. If there were 15 years to go to pay it off, that homeowner now usually has 30 years to go, which for many people could delay retirement significantly. (It is possible to cash out into a 15-year fixed mortgage.)
“If they bought (their home) that long ago, chances are they are approaching or in retirement, and isn’t it nice not to have a mortgage as an expense?” Hollander said.
“A refinance is a new mortgage, so how much can you afford to pay? How do the payments fit in your budget?” Hollander said. “And you are securing the loan with your house. So if you can’t pay, then you have jeopardized your home ownership.
“Much of that is dependent on the individual situation, but debt is debt. Does it make sense for you to be taking on debt?” Hollander asked.
Kenmore said, “Remember what you are doing is locking in a short-term need into a 30-year debt. Even a small amount of money — say, $10,000 — even at 4% interest, you are going to end up paying a lot more money on that $10,000 loan.”
Another expedient, reverse mortgages, are less common than home equity lines or refis, though they are expected to increase. “They tend to be expensive,” Hollander said. “The heirs don’t tend to like it because the bank gets their money out. When you die, the house gets sold.”
Obviously, selling the house is the most radical move, and seldom is undertaken solely for tapping equity.
Home equity for repairs and remodels can make sense
There are limited circumstances under which pulling equity out of one’s home is advisable, the planners said. The most commonly mentioned reason: Home repairs or remodels.
“Sometimes people need to remodel their house to maintain the value,” said Nancy Wright Cooper, a team leader at DeYoe Wealth Management, Inc., in Berkeley. “Perhaps they need to replace the roof.”
Kenmore said, “It can be a very good use of your home equity when doing renovations and protecting the equity you have created in your home.” Deferred maintenance can create nightmare scenarios such as mold or even structural problems caused by water intrusion from leaky windows or a leaky roof, he said.
“You want to make sure you have the capacity to accelerate the paydown of that loan so you are not taking a short-term need and creating a long-term debt,” Kenmore said.
Saving the money to do maintenance or repair is a possibility as well, he said.
“Start with a monthly cash flow exercise and understand your budget. If there is a discretionary amount of capital at the end of the month, can I save $1,000 a month and at the end of 10 months I’ll have $10,000 for the windows,” Kenmore said.
One way to help avoid having to tap home equity is to create a savings plan and establish an emergency fund, which is considered solid financial practice anyway.
“You do want to have funds set aside for an emergency,” Cooper said. Emphasizing that her advice was not meant for any specific individual, but a generalization, she added that “adequate emergency savings and an adequate understanding of what constitutes an emergency is pretty important.”
Kenmore said, “It all depends on what course of action is going to be most prudent for you. I’ve never had somebody come to me and say, ‘Sean, I’ve saved too much money, what do I do with it?'”