Home equity loans seemed ubiquitous in the 2000s, and were often said to have contributed to the economic boom during that decade. Now that borrowers have to start repaying these lines of credits, however, lenders may be fearing a wave of defaults.
As the debt repayment schedule commences for home equity lines of credit, the concern is that many borrowers may face “payment shock” when they realize they have, for instance, “another $400 per month to pay” in loan servicing costs, explains Ezra Becker, vice president, Research and Consulting—Financial Services at TransUnion LLC.
According to TransUnion, about $50 billion to $79 billion of the $474 billion in outstanding home equity lines of credit balances (HELOCs) are at “elevated risk” of default in the next few years. The credit reporting agency says that nearly 16 million consumers in the United States currently hold home equity lines of credit, and that the majority of HELOC balances exceed $100,000.
“Home equity lines of credit were quite popular during the housing boom in the mid-2000s,” says Steve Chaouki, head of financial services at TransUnion. “For many people, HELOCs represented a low-interest rate opportunity to borrow against the value of their homes, which were rapidly appreciating at the time. HELOCs generally had lower interest rates than credit cards or other loan types, and that interest was often tax-deductible.”
When they obtain these home equity loans, borrowers typically have 10 years during which they can draw down their line of credit. At the end of that period, they have to start to repay the interest and principal on the fully amortized loan for another 15 years. When the end-of-draw period hits, “lenders fear there could be a shock to the marketplace” that could possibly, at worse, even give rise to another recession, explains Ezra.
According to TransUnion, more than 92 percent of the total home equity lines of credit have not even reached their end-of-draw period as of the end of 2013. There will be “a big wave of end-of-draws over the next three years that lenders are worried about,” says Becker.
While there may be worries about upcoming loan repayments, Transunion maintains that the cause for concern may not be as big as assumed. The loans with elevated risk of default compose 5 percent of the loans outstanding, and they carry a 25 percent probability of default. “The at-risk population is far more manageable than many people feared,” says Becker.
TransUnion has created metrics to help lenders better manage the home equity loan risks, by helping them to time the end-of-draws and identify which borrowers are at higher risk of default. Credit scores are “immensely powerful for differentiating risks,” says Becker. But cash flow also determines the borrower’s ability to meet the monthly payments, such as borrowers with strong credit scores but weak cash flow may face more difficulty meeting the monthly payments than borrowers with weak credit scores, but strong cash flows. TransUnion also compares the total individual loan balance to housing values in the market as provided by CoreLogic: Consumers with equity in their homes are in a better position to refinance or sell their home to pay off the mortgage, it suggested.
By being able to identify borrowers who are at higher risk of default, lenders can reach out to the customers ahead of time and ask “if they are prepared to absorb the payment shock and what they can do as lenders” to help the borrower continue to make loan payments, says Becker. “This can mean refinancing, restructuring or forbearing the loan. Many times, just notifying [the borrowers] is a big step in the right direction.”