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:
Interest-only features.
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.