HELOCs on the Horizon

The Office of the Comptroller of the Currency published its Semiannual Risk Perspective for the spring of 2012 on July 5^th.  In it, the agency outlined concerns about a potential wave of rate resets on home equity lines of credit (HELOCs) that are set to occur from 2014 until 2017.  While these loans certainly merit concern given the already stressed banking and mortgage finance system, the current market environment has created room for borrowers to absorb the higher costs and primed the banking system to provide aid where needed, which should help to ameliorate this issue.

According to the OCC, on average HELOCs accounted for roughly $500 billion of the combined balance sheets of the banks monitored by the agency in 2010 and that those portfolios fell through 2011.    As a share of all bank assets, HELOCs acount for only 9% compared to 27% for 1-4 family residences and 11% for credit cards.  Furthermore, the charge off rate was roughly 2% in 2011 compared to near 6% for credit cards.

However, as pictured in figure 1, beginning in 2014, the balance on HELOCs that will end their draw (e.g. convert from a line of credit to loan that must be repaid) will begin to rise from $29 billion in 2014 to $73 billion by 2017.  Of concern to the bank regulator isn’t just the size of the blances coming due, rather it is the fact that the value of many of the homes backing these loans has decline, some significantly, and that a majortiy of these loans were interest only (figure 2), meaning that the holder has only paid interest to date and that the rate reset will be joined by principal payments.

An example will help to clarify. For a borrower who took out a HELOC with a balance of 20% of the value of their $200,000 home or $40,000 in 2007,  they would pay $213 a month for the first seven years at the prevailing rate of 6.39% for an interest only 7/1 HELOC in July of 2007.  However, when the loan resets it will change to the prime rate plus the banks profit margin.  While the current prime rate is 3.25%, it is likely to rise, so for this example I’ll use 5.25% plus a margin of 2.0% for a rate of 7.25%.  That would translate into a jump in the monthly payment of $85 for a total of $298, or a 40% increase assuming that the balance of $40,000 is ammoritized over a 23 year period; a shorter period would cause the payment to rise further.  If the prime rate continued to rise, but was capped at 2% per year, by the fifth year the monthly payment would be $481 or a 126% increase as depicted by the blue line below.  A base case where the prime rate hovers at 5.25% is also included in graph.

However, there are some factors in play that would help to ameliorate the payment shock of a rate reset on a interest only HELOC:

1. The prime rate has fallen considerably in recent years due to the weak economy, concerns in Europe, and the sluggish U.S. housing market and currently stands at 3.25%, well below the prevailing HELOC rates of 6.5% or higher back in the period from 2003 to 2007.  A person facing a HELOC reset today might actually receive a lower payment.  However, rates are likely to rise over the next 5 years, so it would be prudent to address the mortgage terms today.
2. Given the record low mortgage rates, the borrower may choose to refinance their primary mortgage.  A homeowner who refinanced from 6.31% (the average in June of 2007) to 3.75% (well above last week’s average of 3.56% according to Freddie Mac) would see a decline in their payment of $374 on a $186,808 loan (the principal balance on a $200,000 mortgage after 5 years of payments). The savings in turn could be used to pay down $8,978 of the priniple on the HELOC, which would lower the payment relative to the worst-case reset scenario (green line charted above).  The lower monthly payment on the first lien could also help to offset or to absorb the difference in HELOC payments after the reset.
3. The borrower may choose to refinance the HELOC in tandem with the 1^st loan if the borrower is not underwater.  Refinancing a $40,000 HELOC at 4.75% would lower the payment from $213 to $209 (purple line in the chart above)…and it would be fixed for the remaineder of the term meaning no payment shock.
4. If the borrower is underwater, they could take advantage of the HARP or HAMP programs to lower the cost of the primary mortgage.  Investor holders of 2^nd leins have been more willing to re-subordinate their loans in recent quarters in recognition that it is in their own interest.
5. HAMP refinances can also modify a 2^nd lien like a HELOC through the 2MP program.
6. As prices rise modestly in the coming years, those not elligible for these programs may become elligible for traditional refinances.
7. Finally, banks and financial institutions have become more aggressive about their own loan modifications as they see it in their own best interest to prevent costly foreclosures.

It is unlikely that any one program will eliminate the problem.  Rather, it will be a combination of factors that ameliorate the impact of the payment shock as well as the impact to banks’ balance sheets as both the outstanding balances and incidence of default decline.

The upsurge in refinances this spring will likely help to stabilize the HELOC situations as homeowners have more funds to pay down HELOC balances prior to any resets.  What’s more, the mortgage finance industry has been primed to respond to this type of problem.  While a government funded bailout of these sector is unlikely, these borrowers can take advantage of current programs to manage their other expenditures.  For REALTORS® this is an opportunity to inform their current or former clients of this situation, adding value to their service and supporting stable prices and confidence in their communities.  It is possible that not enough homeowners will take advantage of the currently available low rate refinancing and that the prime rate might surge in response to robust economic growth by 2015, but it is in the banks’ interest to see that these borrowers achieve stable positions.