According to a new report by the Office of the Comptroller of the Currency (OCC), banks today hold home equity lines of credit (HELOCs) with a total outstanding balance of $11 billion. By 2018, that balance is expected to reach $111 billion, a balance that will mean big problems for many borrowers — and lenders.
A HELOC is a line of credit secured by the borrower’s house, usually as a second lien. The borrower can take money from the line by just writing a check at any point during the “draw” period. If the borrower makes repayments and reduces the debt then the amount available to the homeowner increases up to the credit limit. HELOCs typically have adjustable rates that last 15 to 30 years, and because the loan is secured by real estate the interest cost is generally tax deductible.
The catch is that when the draw period ends the borrower must make amortizing payments. That’s a big deal because the OCC says ‘approximately 58 percent of all HELOC balances are due to start amortizing between 2014 and 2017.” If you don’t make the minimum payments you can be foreclosed. When the loan term ends any outstanding balance must be paid off — in effect a balloon payment is due. Don’t make that huge final payment and, well, you get the idea.
So what could possibly go wrong?
First, home equity nationwide has declined more than 17 percent since 2007, meaning it can be very difficult if not impossible to refinance a second lien of any type.
Second, we have enjoyed historically-low interest rates for several years — but low rates may not be there in the future. Payments and costs which are tolerable today may be difficult if not impossible to pay if rates rise. In today’s fragile economy even a small rate bump could produce payment shock for many borrowers.
Third, when home values went down many lenders suspended the ability of borrowers to withdraw from their home equity lines of credit. In a sense that’s a good thing because frozen HELOC balances could not increase as a result of withdrawals, but money that was supposed to be there for college or to start a business is no longer available.
The real kicker is that with HELOCs people who have been paying their first mortgages could well be foreclosed for failure to pay-off their seconds.
What can be done to prevent HELOC foreclosures?
Borrowers with HELOCs may be able to repay the debt in full with larger monthly payments — if they start now.
But another possibility is this: Lenders may decide to re-structure HELOC debt by lengthening loan terms, cutting interest levels or forgiving principal. Why? Because many HELOCs are simply uncollectable as the notes are now written. If a lender with a second lien forecloses it cannot collect a dime until the first-lien holder is entirely repaid. Foreclosure for second lien holders make no sense when homes have little or no equity so the better option is to accept payments rather than record massive losses.
In the same way lenders now grudgingly understand that short sales are a better option than foreclosures, the same will happen with HELOCs. It’s an ugly choice for lenders, but until home values return what option do they have?
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