While homeowners have record levels of home equity, they seem less inclined to use it to finance home improvement projects. Rising interest rates seem to have spooked owners into using alternative financing sources, which ultimately is likely to slow the growth in home improvement spending. In most markets across the country, house prices have recovered to levels of before the housing crash. With that increase in house prices has come a comparable increase in the home equity held by the typical owner. As of 2017, owners held an average of $190,000 in home equity, twice as much as they held in 2011 at the bottom of the housing market, and 15 percent more than at the last housing market peak in 2006. Growing levels of equity not only give owners more incentive to protect their housing investment; homeowners can also use this equity to help finance a home improvement project.
Offsetting this positive trend is the fact that it’s getting more expensive to tap into this equity. Generally, home equity credit lines are pegged to the prime bank rate, and from 2009 to 2015, the prime rate was around 3 percent, just about as low as it can go. Beginning in late 2015 the Federal Reserve has been pushing up short-term interest rates, and by late March of this year the prime rate was up to 4.75 percent. The consensus is that there will be two more quarter-point interest rate hikes by the Fed this year, and probably another three in 2019. That would bring the prime rate to around 6 percent by the end of next year. So, interest payments on an equity loan for a typical borrower are up about 35 percent since their low in late 2015, and will probably be up another 35 percent by the end of next year. Even though interest rates are low by historical standards, that jump in payments for the typical borrower is significant, and may give them pause.
In fact, rising interest rates, and the prospects of even higher rates in coming quarters has already changed consumer behavior toward how home improvement projects are financed. U.S. banks report that consumer demand for home equity lines of credit grew sharply from early 2014 to mid-year 2016, according to a quarterly survey of senior loan officers conducted by the Federal Reserve Board. From mid-year 2016 to earlier this year, demand for home equity credit lines began to slow somewhat, and with the most recent survey it has declined.
How do homeowners pay for home improvement projects if they are not taking out home equity lines of credit? They might look to financing offered through their contractor or their local home improvement retailer, or simply put what they can on their credit card. However, the most common way to pay for a home improvement project is to use savings. A recent survey by Wall Street investment house Piper Jaffray of households planning on undertaking a major home improvement project over the coming year found that almost six in 10 of these remodeling households were planning on using cash for part or all of their project costs.
If this share of owners relying on cash for their home improvement projects were to increase, it would be a serious setback for home improvement activity. Being able to finance projects allows households to put a decision in the context of how much they can afford in monthly payments rather than how much they currently have in savings. Households that save for the entire cost of a project generally have a lower budget, and certainly have a harder cap for the total cost. Imagine if the automotive or homebuilding industries relied as heavily on cash purchasers for their products. That certainly would dramatically constrain growth.
Kermit Baker is the senior research fellow for the Joint Center of Housing Studies at Harvard University. He may be reached via e-mail at kermit_baker@harvard.edu.