As mortgages decline, so have home equity loans—but their tighter standards make them less prone to go sour
As many mortgages go down with the sinking housing market, most low-risk, low-rate home equity loans should have little trouble finding a lifeboat.
Home equity loans and lines of credit (HELOCs) are usually second mortgages secured against the value of one's property, and used most often to finance home renovations, college education, or medical expenses. In a closed-end home equity loan, the borrower receives a lump sum of the appraised value of the home, and generally pays a fixed rate for a certain period of time, such as 15 years. A HELOC is more like a credit card, in the sense that the lender sets a limit, and the borrower can choose when and how often to tap into the line.
This type of borrowing gained popularity in the housing boom years, as interest rates remained low and prices appreciated. According to an Experian/Gallup Personal Credit Index poll released on Feb. 12, 25% of homeowners have both a first mortgage and a home equity loan or line of credit. Although the recent housing market slowdown has caused mortgage delinquencies to rise across the board (total U.S. foreclosures rose 42% in 2006, according to RealtyTrac), the fate of home equity loans and HELOCs has yet to become an area of concern.
"Home equity loans are the least risky type of personal lending," says Jim Chessen, chief economist of the American Bankers Assn. Borrowers of HELOCs tend to have much better-than-average credit, and underwriting standards are much higher, Chessen says.
According to the ABA, the rate of default on home equity loans actually decreased in the third quarter of 2006, to 1.79% from 1.89% in the second quarter and 2.33% a year earlier. Delinquencies for HELOCs, which are very minimal to begin with, rose to a rate of 0.57% in the third quarter of 2006 from 0.52% in the second quarter and 0.46% a year earlier.
"You're not going to see the type of volume as we saw three or four years ago," says Greg McBride, senior financial analyst at Bankrate.com. "But it's not something that's going to get to an alarming level."
Even though interest rates are higher, and home values are lower in some areas, home equity loans still have much lower rates than credit cards, for example. And, McBride notes, the interest is still tax-deductible.
Watch for Fraud
This is not to say that all home equity borrowers are in the clear. Some home equity lenders offer loans to customers with bad credit, and defaulting on a home equity loan could quickly spiral into foreclosure.
Lenders also need to watch out for fraud. According to a recent report by research and advisory firm Financial Insights, home equity lenders could face millions of dollars in fraud losses, if they don't devise a way to protect themselves.
"[Home equity loans] are a fast-growing product and the second largest product in terms of loan balances," says Christine Pratt, research director of Consumer Banking & Credit at Financial Insights and author of the report. In fact, applications for home equity loans tend to increase when home prices decline, Pratt explains, because people figure they will fix up their homes now and sell them when the market perks up again.
The growing popularity of the product, and its presence on the Internet, is leading to more widespread fraud, Pratt says. She notes a case in which one person last year applied online for three home equity loans at a large U.S. bank based in the South using his father's Social Security number. The borrower didn't own any of the property, and the bank lost $1.2 million.
Even under normal circumstances, lenders dabbling in subprime home equity loans will no doubt suffer the most as mortgage rates increase and homes become subject to market cycles. When borrowers enter foreclosure, "piggyback" loans-home equity loans or lines closed at the same time as a first mortgage-involved don't get repaid until the first mortgage is covered.
Subprime piggyback loans made up the much of HSBC's (HBC) $1.8 billion in bad-debt charges, which the British bank announced on Feb. 8 (see BusinessWeek.com, 2/9/07, "Subprime Time Bomb").
"[HELOCs alone] are not really mentioned yet as problem loans," says Standard & Poor's Equity Research analyst Stuart Plesser. "They could be of course if someone's lending and the home price is declining." Plesser says he would even start to become concerned about HELOCs given to people with a credit score of 680 or lower.
The majority of people have FICO credit scores between 600 and 800, on a scale of 300 to 850. A score of 720 or higher will get you the most favorable interest rates on a mortgage, and most lenders consider anything under 600 risky according to Fair Isaac (FIC), the company that developed the score system.
A loan-to-value ratio of 100% or more could also put a lender at risk, Plesser says. The higher the loan-to-value, the less the buffer there is if the borrower defaults. Higher loan-to-value ratios also come with higher rates.
The difficulty comes in identifying those lenders that give out the most home equity loans or lines to borrowers with less-than-prime credit. Big banks like Wells Fargo (WFC), Bank of America (BAC), Washington Mutual (WM), and Citigroup (C) do the bulk of home equity lending, though analysts say these lenders also tend to be more conservative with regards to their pricing and who they lend to.
Washington Mutual offers HELOCs of 80%, 90%, and 100% of a home's value after a credit evaluation. "In general these have been priced more realistically [than subprime mortgages]," says Plesser.
Most home equity loans appear to be safe, for now. But as the housing market continues to cool, could home equity—once considered foolproof collateral for extra cash—lose its status as a dependable source of income, if only temporarily?
"I don't think that will change," says McBride. "Even if it did change, I would argue that that's a good thing. People need to be more diversified."