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Updated on Thursday, March 5, 2015
Home Equity Lines of Credit (HELOCs) were very popular before the 2008 crisis. If you had equity in your home, you could open a very low cost line of credit, making it easy to borrow against your home. The typical HELOC would have a 10 year drawdown period. During that time, you could use your line of credit by writing checks, transferring funds electronically or even using a special purpose debit card. Yes, you could finance a flat-screen television using your home as collateral.
During the 10-year drawdown period, you would typically only need to make interest-only payments on the amount that you had borrowed. And the interest rates were incredibly competitive. Some bans were even offering interest rates below prime during the drawdown period. For example, if you had a $30,000 balance, your monthly payment could be a low as $50. Even better, that $50 was tax deductible, which meant you would be getting a refund at the end of the year. It became incredibly easy for people to run up significant debt. And, with real estate prices increasing rapidly, borrowers continued to feel wealthy, because the value of their home continued to outrun the balance of their debt.
At the end of the 10 year drawdown period, the payments would convert to a 20 year amortizing loan, at a much higher interest rate. Depending upon your credit score, the interest rate could go from 2% to 9%, for example. In the $30,000 example above, the payment would increase from $50 to $270. That is a dramatic price increase, otherwise referred to as a payment shock.
When these loans were originally sold, brokers and bankers told borrowers not to worry about the rest. The general belief was that house prices would continue to increase, and banks would continue to lend. You could always refinance the balance and go back into another interest-only drawdown period. The promise to borrowers was that you would never have to pay off your debt, and many people believed that promise.
Fast forward 10 years, and many of the HELOCs issued during the crisis are now resetting. But there is a problem: it is almost impossible for subprime borrowers to find a bank willing to lend. And, even worse, 53% of the resetting HELOCs are on properties that are upside down. In other words, the balance of the mortgages is greater than the value of the property, which means no bank will lend, even if the credit score is high.
That creates a big issue for borrowers who can not afford the rate reset. If they can’t afford the new monthly payment, and can not find a new lender willing to underwrite the risk, they will risk foreclosure.
RealtyTrak yesterday released a report detailing the scale of the rests coming. And the story does not look good. 3.3 million HELOCs are scheduled to reset over the next 3 years. The average payment shock will be $140 a month, but a significant number of people will see much bigger resets.
But the real issue is that 53% of the HELOC customers (1.8 million people) are upside down on their property. That means their home is worth less than the balance of their mortgages. For these individuals, they will be at high risk of foreclosure.
The next 3 years will be challenging for borrowers, and we will be watching closely to see what loss mitigation options banks propose. But even principal forgiveness is not without it challenges, as the borrowers may have a tax liability as a result.