The hidden costs of taking cash out of your home

Nearly 60% of cash-out refinancings in 2018 came with higher interest rates (WSJ)

The recent WSJ article on American consumers refinancing at higher rates to take equity out of their home is yet another indication of the product-market mismatch in residential real estate financing.

Paul Thompson, the particular consumer in the piece, replaced his five year-old 4% mortgage with a 4.625% mortgage, taking out $30,000 in the process.  Some back-of-the-envelope calculation show that Paul will be paying $146,530 over the life of the new loan for the opportunity to take out $30,000 in equity.  I didn't account for time value of money or mortgage interest deductibility, but it seems that Paul will need a period of macroeconomic hyperinflation for this to make sense financially.

Showing my work (assumptions)

• He initially took out $350,000 for 30 years; total payments would have been $601,543
• Assuming 60 periods in, he would have paid down $33,433 in principal and $66,824 in interest (totaling $100,257)
• Since he took out $30,000 in equity, I'm further assuming the new mortgage balance will be $350,000
• He will have total principal and interest payments of $647,816 for his new loan.
• [New Loan: $647,816] - ([Old Loan: $601,543] - [Old Loan Paid Down: $100,257]) = $146,530

Can home equity loans help another group feeling the pinch?

Imagine the shock reading about yet another group being left behind, this time, those in the upper half of the the wealth pyramid below the top 10 percent?  As is my predilection, familiar to my devoted reader, I immediately focused on the impact of housing.

Source: Bloomberg Business

The above chart shows that, even after a decade of de-levering and then re-levering with the tailwind of an extended run-up of home prices, the share of housing debt as a portion of total indebtedness has dropped substantially.  The author then serves up a chart on rising debt service costs to back up his contention about households shifting to higher interest rate debt categories.

Can Home Equity Loans Help? 

Source: Black Knight February 2019 Mortgage Monitor

Abundantly clear from the above chart is that consumers are currently sitting on nearly 2.2x more tappable equity than at the end of the recession, despite multiple first mortgage refinance waves that have soaked up significant excess home equity.

Moreover, both HELOC balances and limits have come down in during the period in question while credit card balances and limits have risen.

Finally, when debt share by product is compared between two age cohorts (30-49 vs. 50-69), one notices a material difference in HELOC adoption.  One also sees that there could be economic value in substituting HELOCs for higher cost credit card debt in both cohorts.

Any Conclusions?

No slam dunks here, but there's evidence that, beneath the headlines around tappable home equity, there's clear indication of changing consumer behaviors, and not necessarily for the better.  There's also an opportunity for consumers to save substantially by moving from higher cost credit card debt to some form of secured home equity loans.

Are millennials using HELOCs differently?

Definitely, Maybe...  With all due respect to the Ryan Reynolds Kevin Kline flick from a decade back, I'm still unsure about passing judgment on the recent Citizens Bank survey of customers regarding their plans for HELOC proceeds.  The survey showed that, while 70% of the respondents would use those funds for home improvement, Millennials had greater propensity toward alternate applications: 1.8x more likely to avail themselves to time off from work for family care, and 2.1x more likely to pay for a vacation, 2.4x more likely to fund a new business venture.

Maybe?
This observation possesses a certain coherence, that a cohort who came of age having both the ability, through product and tech innovations, and the need, due ever-greater student loan debt load, to manage cash flow in a controlled, granular fashion would continue such behavior into their home ownership life stage.

Maybe Not?
Home improvement spending tends to be episodic, often hitting a multi-year lull after the initial flurry in the months following the home buy.  When matched against reasonable levels of home equity appreciation and the recent vintages of most Millennial home ownership, one can posit that, at the time of survey, this generation would be under-indexed in considering home improvements in the first place.

Definitely, Maybe?
While this particular study may not be conclusive, I'm still of the opinion that the future of home equity usage will be less open-ended blank check and more situational, with balance and duration matched to purpose/context.  To expand on a prior post regarding the recent J.D. Power HELOC study, the first order derivative of digital will be control.  Once consumers have the former, they will desire the latter.  And once they possess the latter, they will be even more dissatisfied with the current state of the HELOC product, especially when compared to their other financial products.

Taking out a HELOC is a consumer's way of loading up on liquidity.  Recalling my experiences in institutional banking, the time to load up on liquidity is when a company is heading into choppy waters, not when everything's great.  With an ever-growing abundance of liquidity options for consumers on the spot market, one wonders if these same HELOC borrowers, who the survey also reveals has having "an overwhelming sense of optimism, with 87% saying they were optimistic about their home’s value," would prefer an alternative that enables more situational/purpose-driven usage.

HELOC "perfect storm"

"Despite record-high levels, new home equity line of credit (HELOC) originations have been steadily declining as a perfect storm of rising interest rates, new tax laws and growing competition from alternative lenders has crimped traditional HELOC growth." (J.D. Power 2019 U.S. Home Equity Line of Credit Satisfaction Study)

This must be one heck of a slow moving storm since the underlying "new normal" had its genesis sometime in 2013 when the traditional lagged correlation between HELOC originations and the Case Shiller HPI started to break.  I had created this visualization a year ago, but this conundrum has, if anything, further under-performed even the lowered expectations.

Much of the reaction to this study has been a freak out around...

(KEY FINDING #1) how consumers are increasingly considering alternate product, two-thirds compared to a bit over 40% a "few years ago," leading to exhortations about...

(KEY FINDING #2) ...the need to go digital.

The peanut gallery has a point here.  As someone who took out a HELOC recently, I can attest that not only is the customer experience every bit as antiquated as that of a decade ago, it has actually, worsened through the inclusion of myriad InfoSec requirements.  While my institution was a legacy bank, even the new entrants are sadly lacking in "digital."  One only has to check out PennyMac's ballyhooed first fully non-bank HELOC product where digital is apparently defined as a form that drives a loan officer to call you.

I'm frankly more interested in the other two findings...

(KEY FINDING #3) "Concerns about interest rates, overextending debt drive shopping behavior: Customers concerned about opening a HELOC are significantly more likely to consider HELOC alternatives." and

(KEY FINDING #4) "Long-term HELOC customers less engaged than new customers: Existing HELOC customers who have had their line of credit for more than two years are notably less satisfied with their lender than are new customers."

These two findings point to a product-market mismatch issue that has been evident elsewhere in consumer finance, where consumer preferences have driven increased usage of debit cards and purpose-driven loans over credit cards.  Consumers are prioritizing control and transparency, while recognizing the costs of open-ended credit.  Moreover, given that consumers' financial priorities will likely change, sometimes dramatically, over a typical HELOC draw period, does it really make sense to keep the line open for such lengthy timelines?  This is a likely cause for the final finding around lower customer engagement/satisfaction over time.

The tech-enabled ready availability of credit, appropriately priced with intelligence on purpose or context, has truly been transformational, but the HELOC segment has, for the most part, been oblivious to this sea change.

Thankfully, this obliviousness is not universal.  Figure's HELOC possesses attributes that address the issues identified in the findings of the study, including: (1) transparency and availability for digital discovery; (2) speedy origination process without need for human handholding; (3) fixed rate/terms providing customers with easy-to-understand exposure; and (4) a generally favorable cost-benefit CX equation that enables consumers to regard taking out a Figure HELOC as situational.  In many ways, Figure has the first HELOC geared around how consumers behave now, not ten years ago.

This year looks to be a banner year for other new HELOC-type products, with Blend, Prosper and SpringEQ all about to unveil their own takes on cracking the conundrum.  I can't wait to see what develops in this space.