Stashed away in millions of homes is a ticking financial time bomb. Of course, it didn’t seem this way at first: When homeowners first lit the fuse home equity lines of credit — HELOCs — were seen as a way to quickly and cheaply access fast-rising home equity, the just reward for homeownership.
The problem is that in the end a HELOC is nothing but a mortgage, a loan which has to be repaid. And now, for large numbers of homeowners, the time to pay-up has come. According to Reuters, more than $220 billion in HELOC debt will become earned, due and payable during the next four years. Unfortunately, a lot of property owners will be unable to pay-off such liabilities.
Between 2000 and 2004, homeowner equity rose from $12.6 trillion to $18.6 billion trillion. American real estate had been rising at a fast clip and homeowners wanted to access rising equity for several reasons:
First, it was there — trillions of dollars in untapped equity. Financial gurus said not using that untapped equity was an economic sin, an asset that wasn’t working for the homeowner.
Second, it was the right debt to have because interest on HELOC financing was tax deductible while taxpayers could not write off the cost of credit card or auto debt.
Third, HELOCs represented quick access to large sums of capital, perhaps enough to start a business, buy another house or pay for a college education.
Getting a HELOC was virtually instant and automatic. Not only did borrowers have real estate equity, such equity was growing. This meant lenders had virtually no risk because the security for the loan was increasing in value. Or at least that was the thinking of the day.
To make the process easier, homeowners were bombarded with free HELOC offers. Sign up today and lenders would pay all closing costs.
When the mortgage meltdown hit it was borrowers with first mortgages who were in trouble, typically property owners who financed with toxic loans such as option ARMs, interest-only mortgages and loans originated with “no doc” mortgage applications. HELOC borrowers drifted serenely along, largely untroubled by the financial mayhem around them.
HELOC borrowers lucked out because their loans were typically structured like credit card borrowing: As long as homeowners made minimum monthly payments lenders were happy, the loan was “performing” — at least on paper. Because HELOCs were commonly far-smaller than first-mortgages, the payments were very tolerable for most borrowers.
In addition, once the mortgage crisis was apparent lenders curtailed large numbers of HELOCs. By 2006 it was virtually impossible to get a HELOC, and by 2008 many lenders had severed credit lines. If you had a $100,000 line of credit and $40,000 had been used the balance was suddenly off limits. Most borrowers — if not virtually all borrowers — did not know that lenders had the right to curtail withdrawals when home equity values declined. There was a lot of howling and screaming when lenders closed the tap but for many borrowers the curtailments were probably a good thing because they limited debt.
Ten years ago was 2004, a time when real estate equity was quickly growing. Spring forward to 2014 and a lot of HELOC borrowers are about to be in trouble. The reason is that HELOCs have to be repaid at some point and for many borrowers now is the time.
While HELOCs are a form of real estate financing many, if not most, were structured like credit cards: The lender was happy to get a monthly minimum payment because that meant more principal was outstanding for a longer period of time so there was more interest to be earned. With rising equity values repayment was not a worry because in the worst case the property could just be refinanced. Of course, if home values fell and unemployment rose all bets were off — a lot of borrowers would eventually be foreclosed.
Many HELOCs were structured so that there was a “draw period” of five or ten years and then the rest of the loan term was reserved for repayment. Others were simply 10- or 15-year notes, they end abruptly and whatever is owed is owed.
HELOCs routinely were in the form of an ARM so that as interest rates rose or fell so too did payment requirements. The good news for HELOC borrowers is that the past few years have seen interest levels crash to historic lows, something which cushions the blow of unpaid HELOC debt.
What happens as HELOCs start coming due?
For borrowers the options range of gleeful to grim:
- The draw period ends and new monthly payments are based on making the existing loan balance self-amortizing over the remaining term of the loan, perhaps 5, 10 or 15 remaining years. The result may be sharply-higher monthly costs.
- The loan simply ends, say after 10 years. In effect, the HELOC becomes a massive balloon note which must be repaid.
- The HELOC debt is small so the borrower repays from savings.
- The debt is small enough so the borrower is able to repay by getting cash from credit cards. Not a low-cost solution but better than foreclosure.
- Equity has been rising so the borrower sells the property and repays the debt.
- The borrower contacts the loan servicer and gets the loan extended for a year, postponing the problem.
- The borrower refinances both the first mortgage and the HELOC, replacing two loans with one at today’s interest levels, possibly with federal help under the Making Homes Affordable programs.
- The borrower settles the debt with a partial payment. Problem: A big credit ding plus unpaid mortgage debt may now be regarded as taxable income by the federal government unless Congress restores the Mortgage Forgiveness Debt Relief Act of 2007, legislation which expired at the end of 2013. See a tax pro for details.
- The borrower is unable to sell, refinance or pay off the debt. The home is foreclosed.
It’s the last option which is causing unease in the financial arena. As RealtyTrac points out, despite rising real estate values 9.3 million homes remain “deeply underwater,” meaning the amount of debt with these properties is at least 25 percent greater than the equity value of the houses. It is these homes, especially, which are most likely face foreclosure as long-dormant HELOCs spring to life.