Financial advisors may need to don debt management caps now that banks are freezing and/or cutting client home lines of credit (HELOCs) amid falling home values.
A decade ago, home equity credit lines seemed a great way to get tax-deductible interest on a loan that could consolidate debt, pay for college or make home improvements. But for many borrowers, these loans have morphed into lemons. After 2000, the home equity credit line was often used as a "piggyback" loan. Borrowers without upfront cash could buy a home without obtaining private mortgage insurance. The borrower might put 5% down on the house, and take out a home equity credit line for 15%.
Now, delinquencies for the collateralized home equity credit line are at record levels since 1987-1.10% in the first quarter of 2008, according to the American Bankers Association.
This may not seem like much. Nevertheless, at least 50% of domestic lenders in the Federal Reserve's April Senior Loan Officer Opinion Survey said they had tightened terms on existing HELOCs in the past six months because of falling home values. Its July poll indicated 60% expected to tighten credit standards for approving HELOC applications through 2008, and roughly 40% anticipated tightening in the first half of 2009.
Among those reported to have cut or frozen the home equity credit lines of existing borrowers: Bank of America, Citigroup, JPMorgan Chase, Washington Mutual and USAA. Even giant securities firm Morgan Stanley was among those tightening its credit line terms to existing borrowers.
Elisabeth C. Plax, a CFP licensee in Beachwood, Ohio, warns that, contrary to popular belief, credit freezes can impact people with excellent credit ratings. "What it's doing is catching people unaware," she says. Among those who will be stuck, she fears, are people who are using credit in a very responsible way-to pay for college tuition, medical expenses or home improvement projects that they may have already started.
Her concern is that credit freezes may lower the credit score of a client by no fault of his own. If you have a $100,000 credit line slashed to $50,000, but you've borrowed $50,000, she notes, your newly maxed-out state reduces your credit score. This, she says, can be particularly devastating for anyone who already has a credit problem.
Other advisors are eliminating circumstances under which they'll recommend HELOCs. Ben Utley, a CFP licensee with Physicians Family Financial Advisors in Eugene, Ore., says he still recommends that his doctor clients open a home equity credit line. Often, they have occasional calls for cash-such as a $50,000 tax bill in April.
But he also previously encouraged his clients to use HELOCs as bridge loans while selling a first home and buying a second, and he now no longer advocates that strategy. In these illiquid times, Utley says, there is less risk if they sell the first house or rent before buying the second home.
Even the highest-net-worth individuals with sterling credit are not immune from the credit squeeze. "The point is, we're all looking at the same landscape, where housing prices are going down in many markets, and substantially in some markets," says Tom Kelly, spokesman for JPMorgan Chase.
JPMorgan had already been monitoring its loans and cutting lines for those who might be having problems managing credit, and it had tightened standards for new loans "five or six" times; the maximum amount of home equity it would loan has dropped from 100% of appraised value in the spring of 2007 to as little as 60% in certain markets by August. Then in March, the bank mailed letters to some 150,000 good customers and said it would be freezing or reducing credit lines because of lower home values. The letters suggested that if there are special circumstances, borrowers should contact the bank.
Once hailed as a way to borrow more than 100% of the value of a home, the home equity line has become problematic for many. Consumers at the blog Caveatemptorblog.com rant about large amounts of bounced-check fees triggered by the slow notifications of credit line freezes. Others complain about being cut off from desperately needed funds. Businesspeople who rely on home equity lines to cover business cash flow shortfalls are experiencing financial problems.
"From my understanding, it's a contract issue," says Sam Glover, the Minneapolis consumer rights attorney who runs the Web site. "The home owners who are facing this issue need to look at their contracts. Contracts I have seen say banks have the right to do it. The question: Do they get to do it based on an estimate of home value or do they have to have an appraisal?"
One victim of the home equity credit line freeze who may contest the terms of his contract is Beverly Hills consumer class action attorney Brian Rishwain. The rationale, Rishwain says, was that his home is now worth 60% less than its original appraisal nine months earlier.
Rishwain, who is expecting to file a class action lawsuit, says he paid $425 for an appraisal to successfully prove his bank wrong. Although he won the appeal when his appraiser reported his home value had dropped only 5%, his bank, at least initially, declined to reimburse him for the full appraisal fee. Its limit was $350.
"One guy I'm dealing with [a potential legal client] relies on [a home equity line] to make payroll when money might be tight," Rishwain says. At least one lender, he adds, will let you appeal a freeze-but only if you agree to use that lender's high-priced appraisers!
David Kammerer, a mortgage broker with Pacific Crest Trail in Eugene, Ore., had his personal home equity credit line frozen, though the repayment terms remain unchanged. While he lost the ability to borrow more off the credit line, he's content to continue paying off his outstanding balance at what he considers a still-attractive rate.
Nevertheless, he no longer is brokering home equity credit lines to clients because of poor customer service from wholesalers. Instead, he'll escort longtime clients to a local bank or credit union that he knows offers attractive home equity line terms. He'll help them understand the terms of those loans at no charge as a goodwill gesture.
While it's still possible to find attractively priced home equity credit lines today, he says, employees at smaller institutions offering the better products lack product knowledge. They also lack the skills to steer clients to the best deals.
"I specifically tell [clients] they need to ask for the home equity loan department," he says. "Most banks have somebody there designated as a home equity loan officer. The problem is, they're doing 18 other things."
Clients also need to shop around because of the wide disparity of rates and terms offered, he says. Although lenders are freezing or cutting credit lines, there are consumer protections in place to prevent abuse.
The FDIC on June 26 issued a Financial Institution Letter addressing the issue of changing home equity credit line limits. Such actions may be prudent, it says. But legal requirements designed to protect consumers must be followed. It warned that Regulation B, which implements the Equal Credit Opportunity Act, and the Fair Housing Act require lenders to use "consistently applied fact-based methods" in calculating revised property values and determining borrower financial circumstances.
It also urged institutions to work with existing borrowers, when possible, to mitigate financial hardships arising from HELOC reductions or suspensions. The Office of the Comptroller of the Currency, regulator of national banks, says it addresses these issues in ongoing on-site bank examinations.
Stuart Feldstein, president of SMR Research in Hackettstown, N.J., blames home equity lines that are used as piggyback loans for most of the problems. Usually, these loans were used so borrowers without up-front cash could buy a home without obtaining private mortgage insurance.
The problem, he says, is piggybacks were being made to borrowers who already lacked cash. "When you make loans to people who don't have much cash, you have to scratch your head," he says. "The foreclosure rate, last we looked, on people who had piggyback loans was seven times greater than those who had freestanding loans. The freestanding loans are performing quite well."
Unfortunately, this doesn't matter to lenders. If home values are plummeting and a home equity line borrower has any problem, the lender knows he or she won't get paid.
Feldstein predicts home equity credit lines will be attractive to consumers again by next summer. "What's the prime rate today? Pretty darn low. Borrowers can use this money to pay off an 18% rate on a credit card."
So what can you do if a client is strapped by a home equity credit line freeze? Rishwain suggests that if a client has a home equity credit line, needs cash and hasn't yet received a lender letter, it could pay to draw down the credit line and put the cash someplace safe. Bank CDs or triple-A-rated bonds may be options.
Clients also should appeal lender decisions, he says. "Unless people aptly appeal, there's no way to know whether the bank is right." In discussions with his own lender, Rishwain says he learned that only 1% of those who had their home equity credit lines frozen or slashed were appealing.
"The bottom line is there is a contract between the banks and the borrowers," Rishwain says. Many lenders, he says, may use an automated valuation model that attempts to do what live appraisers do, "except that it does so with cryptic data from a pool of information within your own zip code."
Indeed, JP Morgan Chase acknowledges it uses an automated valuation model supplied by First American CoreLogic, a division of Santa Ana, Calif.-based First American Corporation. That company, according to Robert Walker, executive vice president, denies some reports that it relies exclusively on "assessed values." Assessed values, upon which property taxes are factored, generally are significantly lower than market values. Instead, Walker says his company's model "takes into account" the latest sales prices and sale dates for nearby properties. In many markets, he says, it uses the listing price of a subject property as the upper end of value.
Pay attention to when the bank sends the letter, Rishwain advises. A lender can't send you a letter on the fifth of the month saying that your credit line will be cut off on the second.
Eileen Freiburger, a CFP licensee with ESF Financial Planning Group, Manhattan Beach, Calif., says she sends her clients to Schwab Bank. That bank, at least as of this writing, she says, had not frozen home equity credit lines or cut limits. Also, she notes, it offered an interest rate as low as 1% below prime.