Warnings are sounded as home equity credit is extended to stretched borrowers.
Although home equity lines of credit are a useful
financial planning tool, a growing chorus of experts is concerned that
consumers could be overextending themselves as rates rise.
Advisors sometimes encourage a client to take out a home equity credit line because of its flexibility and tax advantages. The rates on this type of loan often are lower than credit card rates. And because the loan interest is tax-deductible, the credit line may be used to consolidate debt, pay for college or as a source of investment capital.
But some fear home equity lines of credit, known as "HELOCs," are a ticking time bomb. Reason: They typically have variable interest rates, and frequently, interest-only minimum required payments. This means borrowers can ultimately find themselves saddled either with a required balloon payment or negative amortization-a growing loan balance even though they're making regular monthly payments.
"They're (banking regulators) calling it the ATM machine of consumers," says David Olson, managing director of Wholesale Access, in Columbia, Md. "I see delinquency rising. People are spending more than they earn."
Olson likens home equity credit lines to a big credit card. The difference: Consumers typically don't draw down much more than $8,000 on a credit card. On a home equity credit line, the balances can be $100,000 or even $1 million. "The average balance is over $40,000," he says.
The largest players in home equity credit lines are believed to be Wells Fargo & Co., Bank of America Corp. JP Morgan Chase & Co., Washington Mutual Inc. and Wachovia Corp. Last May, banking regulators issued interagency guidance to financial institutions for home equity lending. Among the concerns raised:
Limited or no documentation of a borrower's assets, employment and income.
Higher loan-to-value and debt-to-income ratios.
Lower credit risk scores for underwriting home equity loans.
Greater use of automated valuation models and other collateral evaluation tools for the development of appraisals and evaluations.
An increase in the number of transactions generated through a loan broker or other third party.
As more players woo customers to this lucrative and secured loan, lenders have been getting more aggressive. The Federal Deposit Insurance Corporation (FDIC) cites several newer wrinkles to obtain home equity line business and increase usage. Not all necessarily are in the best interest of the borrower.
For example, there are now home equity lines that let borrowers finance a home purchase plus remodeling, based on the home's value after improvements were made. Some lenders automatically increase the homeowner's line of credit as the home appreciates in value. There are nonuse fees on open lines that are inactive; interest rate discounts for increased usage; introductory rate reimbursement fees if a loan balance is not maintained for a specified period; rewards for loan reps if funds are drawn within six months after a line is opened; and access by reward credit cards, which issue points toward cash, merchandise or travel.
The increased use of this secured debt has profound implications for the economy-particularly in the event of a housing bust. The FDIC has expressed concern that home equity line borrowers are unaware that the higher their use of their loan, the more their credit score is negatively impacted. And if interest rates rise, homeowners could find themselves saddled with even more debt.
Home equity line of credit growth was reported to have slowed in latter 2005, as fixed-rate home equity loans gained favor. The utilization rate on home equity lines of credit went from a high of 51% at year-end 2004 to 48.8% toward year-end 2005, says FDIC Chief Economist Richard Brown.
But home equity credit lines today are going to borrowers who pose a credit risk and those who don't necessarily live in their homes. A recent survey of lenders by the Consumer Bankers Association of America in Arlington, Va., indicated that home equity lines of credit, as of June 2005, had grown 25% over the prior year. Fully 82% of bank respondents said they loan a maximum of 100% of the value of a home for home equity lines of credit. And 88% of respondents reported originating C- or D-rated credits during the study period. That means they issued lines to riskier borrowers with FICO credit scores of less than 630.
The American Bankers Association noted that in the second quarter of this year, home equity loan delinquencies rose to 2.75% from 2.61%. That wasn't as bad as credit card delinquency, which claimed a record 4.81% of accounts. But FDIC chief economist Brown says that home equity loans as a percentage of disposable income have risen "pretty rapidly from 6% in 1999 to 10.2% in 2004."
Brown says you won't necessarily see things blowing up, because changes don't occur so precipitously from quarter to quarter. Rather, slower home-price appreciation may prove stressful and certain borrowers may not be able to repay.
Others say there is no need for alarm. "We're predicting an increase in bad debt in home equity lending going forward," says George Yacik, vice president of SMR Research in Hackettstown, N.J. "But the rate of bad debt is so low in home equity lending, it's almost nonmeasurable. Any increase is going to be minor and won't affect banks that much. These are loans that are pretty much superclean."
Although home equity debt could ultimately become a nationwide problem, financial advisors say a home equity line of credit can be useful if used judiciously. Steve Wightman, a CFP licensee of Lexington, Mass., a fee-only advisor, says he likes them for emergencies, in addition to three to six months of cash living expenses.
Wightman also might advise clients to switch to a home equity line if they're paying, say, at least 18% on consumer credit. "A lot depends on the creditworthiness of the client," he says, but "I get them out of debt fairly quickly."
When interest rates are low, he also uses a strategy he dubs the "GoldenEye," named after the James Bond movie. Here's an example of how it works: He gets a 4% fixed rate on a home equity line of credit. A client invests the proceeds in conservative investments earning, say 7% interest. Investments might include U.S. Treasury bonds or money market funds. He also has used this tactic with REITs. This way, his client deducts the HELOC interest on income taxes, and earns, say, a 3% net rate over what he is paying.
The GoldenEye is limited to situations in which the client has cash reserves some ten times greater than the amount borrowed. Under these conditions, Wightman says, it's an effective strategy to pay off a mortgage or raise capital for college. Among his rules: He locks in a fixed rate and deals only with reputable banks and credit unions that have been around a long time. Often, he reviews solicitations his clients have received, and may suggest a better deal.
His HELOC recommendations are limited to people with exceptional credit and use of the borrowed money is limited. The lines must have low interest rates, no penalties for retaining them and no fees greater than about $5 monthly. He won't recommend a HELOC to pay for a child's college education. "College should be the primary burden of the child and not the parents."
Edward Mendlowitz, a CPA with Withum, Smith & Brown, in New Brunswick, N.J., has suggested home equity loans to help clients take early withdrawals from an IRA if they need cash. It works this way: The 10% IRS penalty does not apply if the money is taken out as an annuity over an individual's life expectancy or joint life expectancy. So a client who has $100,000 in an IRA could take out a $100,000 home equity loan. Payments on the home equity loan would be made with annuity payments from the IRA. The annuity payments are taxable as ordinary income, but the interest on the mortgage loan is tax deductible. As a result, IRA annuity payments are tax-sheltered by the home equity loan interest deduction.