Our last blog post (blog post 2) talked about how the wealthy borrow against their assets to generate additional wealth or cover expenses in a tax efficient way. One of the most stable and easiest assets to borrow against is real estate given its stable price relative to other securities. Indeed, an average homeowner can borrow against the equity in their home just as easily as the wealthy can borrow against theirs.
This is due to the prevalence of home equity loans (“HELOANs”) and home equity lines of credit (“HELOCs”). HELOANs and HELOCs have been around since the Great Depression but began growing in popularity in the 1970s and 1980s when larger banks began to offer them, and then were rapidly adopted following the Tax Reform Act of 1986 which stated that interest on standard consumer loans was no longer tax deductible, but that home loans were considered exempt from these new restrictions.
Two types of home loans: closed-end and open-end
The two basic types of home loans are HELOANs and HELOCs, both of which are considered “second mortgages”.
A HELOAN is considered to be “closed-end” while a HELOC is “open-end”. A closed-end loan involves a fixed amount of money; the borrower receives the entire loan amount in a lump sum upon completing the loan process. Most HELOANs have a fixed interest rate with a fixed repayment schedule.
With open-end loans, or HELOCs, borrowers do not take the full loan amount at one time, instead they receive the loan as a line of credit that has a maximum amount that the homeowner can draw when the borrower desires. Borrowers can take money from the HELOC at any time and are only required to pay back the amount drawn.
Traditionally, HELOCs offer adjustable rates throughout the life of the loan. There is typically a draw period (10 years, on average), during which the borrower can draw funds repeatedly with minimal repayment requirements, followed by a repayment period (10 years or more) whereby the outstanding balance is amortized, and no new draws can be completed by the homeowner.
Growth of HELOCs
Following the Tax Reform Act of 1986, home loans began to surge and continued to grow rapidly through the 1990s.
From 1987 through 1999, HELOC balances grew rapidly, increasing from $24 billion in June 1987 to $103 billion in December 1999, an increase of nearly 400%. This is shown in Exhibit 1 below.
It is interesting to note that the rate of growth for HELOCs in this period was consistently positive. Of the 603 weeks in the measurement period (June 1988 – December 1999), over 85% of them had a positive annual growth rate. This demonstrates consistent growth during this period.
Exhibit 1: June 1987 – December 1999
From January 2000 through December 2010, the market continued to explode, rising over 6x to reach $611 billion in May 2009 in the depths of the financial crisis. The market then contracted over the next decade before bottoming out in April 2022 and starting to rise again.
Exhibit 2: January 2000 – November 2022
Takeaway: Home loans have been popular for decades and only over the past decade was there a slowdown, primarily due to the housing crisis of 2008. Also, since 2008, interest rates have fallen to historically low levels. This allowed homeowners to take equity out of their home via cash-out refinances whereby the homeowner refinanced their first mortgage with a lower interest rate (and could receive some excess cash in the process). Now that interest rates are rising again, there is no longer demand for refinances, making home loans (Both HELOANs and HELOCs) the most attractive option to tap into home equity.
In our next blog post we will discuss home loans versus cash-out refinances, and how the rising interest rate environment makes it an ideal time for a homeowner to use home loans.
