Mary’s $70,000 Home Equity Line of Credit, a HELOC loan, had prevented her from selling her home in Cameron Park. Although her home’s value had increased since 2008, she was still under water; her mortgages exceeded her home’s current value. Then she received a letter from her bank that could force her into a short sale or foreclosure. What had seemed sensible in 2005 had now become a serious threat to losing her home.
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Mary and millions of homeowners like her are in for payment sticker shock with their HELOC loans. Millions of those loans will re-set themselves in the next three years from an interest-only loan to a fully amortized 10- or 15-year loan. Federal regulators, credit rating agencies and analysts are alarmed at the potential risk to the housing market. The U.S. Office of the Comptroller of the Currency, a regulator overseeing national banks, has issued a warning to banks about the risks of home equity lines and the potential of defaults. So how serious is this problem?
According to a recent report issued by TransUnion, nearly 16 million U.S. consumers have approximately $474 billion in balances on their HELOCs. The study indicated that anywhere between $50 billion and $80 billion could be at elevated risk of default within the next few years. At a Washington, D.C., conference Amy Crews Cutts, chief economist at consumer credit agency Equifax, told mortgage bankers that an increase in tens of thousands of homeowners’ monthly payments on these home equity lines is a pending “wave of disaster.” The threat is particularly pronounced in California where bubble home prices, risky lending and a culture of debt led up to the housing meltdown and the Great Recession.
HELOCs were popular during the mid-2000s when home values were setting record highs. The loan allowed homeowners to open up a line of credit using their house as collateral. Unlike a conventional loan where the amount borrowed is the total amount financed, a HELOC is a line of credit allowing homeowners to borrower up to a predetermined amount. Much like a credit card where interest is only charged against the outstanding amount. With a conventional home equity loan, the borrower receives a lump sum and makes monthly payments on the amount borrowed, usually at a fixed rate. The interest rates with HELOCs are adjustable, interest only and after 10 years, convert to a loan with a repayment schedule.
For many Californians these loans were an easy opportunity to take advantage of the increased value of their homes. The loans had many advantages over conventional loans. They could be obtained in a few days, generally no appraisal was required and the closing costs were minimum. The interest rates on HELOCs was below rates found on other conventional loans or credit cards and generally the interest was tax-deductible. The monthly payments were attractively low, structured as interest only loans and the money could be used for any reason.
Millions of homeowners cashed in on their equity bonanza using HELOCs and paid off credit cards and purchased more stuff. And why not? California real estate always appreciated. Refinancing or selling the home for a profit was a guaranteed option. Subsequently, most HELOC borrowers never gave much thought to how or when the loan would be paid off. Few borrowers read the fine print about paying the loan back. Now that time is drawing near.
The outstanding balance on HELOCs are significant. Fifty-two percent have balances exceeding $100,000 and 75 percent have balances above $75,000. TransUnion’s research found that half of all HELOC loans with balances were originated between 2005 and 2007. Most had a 10-year “end of draw” (EOD) period. The point where borrowers may no longer borrow funds from their line of credit and must repay the outstanding balance will fully amortized payments, i.e. payments of both principal and interest. That bump in monthly payments can put a serious dent in the family budget.
Mary’s current monthly payment on her $70,000 HELOC has been $204. Her new payment beginning next year would be $740. The increase in monthly payment comes at a time when Mary’s earnings are less than what they were 10 years ago, when she took out the loan, while other household expenses have increased. Mary doesn’t have any equity so a sale or refinance is not an option. If she can’t make the increased payment her home would be at risk of default and foreclosure.
Lenders are attempting to be proactive with borrowers like Mary who they have identified as being in a default risk category. Lenders and their investors in HELOCs stand to lose big when a HELOC goes into default. HELOCs have no mortgage insurance coverage which reimburses lenders for their loss in the event of a defaulting borrower. In the event of a foreclosure, a HELOC is in second position to a first mortgage and is erased when the first mortgage forecloses to protect its own position.
Most HELOC borrowers will likely be able to handle the payment increase. If not, there may be alternatives — IF property values increase, IF they are able to sell or refinance, IF lenders will rewrite the interest only loan for another 10 years and IF the current interest rates hold. All big IFs.
Ken Calhoon is a local real estate broker. He can be reached at [email protected].