Increasing numbers of economists and housing experts worry that home equity lines of credit (HELOCs) are poised to become the next big financial crisis to hit the housing sector, given a disturbing collision course of sudden principal due, rising interest rates and the exploding number of bubble-era HELOCs about to reset.
HELOCs typically have a ten year period when borrowers can draw on the line of credit and are not required to pay down the principal balance, they are only required to make interest payments each month. After ten years, the credit line resets, and the borrower must then begin making principal and interest payments each month (like a normal mortgage loan).
These monthly payments that include principal are, of course, substantially higher than prior interest-only payments.
Rewinding to 2004, the real estate bubble was rocketing to new heights, and thousands of homeowners and real estate investors took advantage of these flexible loans to maximize their leverage on real estate. The Office of the Comptroller of the Currency (OCC) released a report with some troubling forecasts: nearly $30 billion in HELOCs are due for their ten-year reset in 2014, and the outlook only grows worse from there: $53 billion in HELOCs will reset in 2015, and by 2018, a whopping $111 billion in these credit lines will reset.
In fact, the majority of HELOCs in America will reset over the next four years, according to the OCC: "Approximately 58% of all HELOC balances are due to start amortizing between 2014 and 2017."
To make matters worse, most HELOCs have adjustable interest rates, generally tied to the prime rate (which changes based on the Federal Reserve's actions). While interest rates have been extremely low for the last five years to aid the economic recovery, they have nowhere to go but up over the coming years. Borrowers will be hit with a one-two punch combination: higher interest rates and the sudden addition of principal payments due.
Nor are borrowers the only ones who will feel the pain. Lenders will be faced with a difficult decision when borrowers start defaulting – foreclose on the property, make a risky refinance or modify the loan terms at a loss. And with roughly 23% of America’s homeowners underwater on their home, refinancing will be out of the question for many of these loans.
This comes at a time when credit has finally begun to loosen up, with many first-time homebuyers just now starting to qualify for mortgage programs that have been extremely restrictive since 2008. If banks face a new round of loan losses, credit markets will tighten up faster than a... well, insert a crass metaphor of choice. But the result is fewer borrowers able to qualify for mortgage and home equity loans, which is hard on both housing markets and small businesses/entrepreneurs who need additional capital.
Some banks are already bracing themselves for a wave of HELOC defaults, and diverting funds to set aside more reserves to cover upcoming losses. Citigroup holds roughly $20 billion in home equity lines of credit, and another $10 billion in home equity loans, and announced last month that they plan to increase the $5.7 billion in reserves they current keep as a buffer to protect against losses from defaults on these loans. But diverting more money for reserves means less money available for lending to homebuyers and small businesses – a sign that credit markets may reverse and start tightening once again.
Homeowners and real estate investors with lines of credit should double check when their credit lines are due to reset, and should be prepared for the payment shock. Those with substantial equity might consider refinancing at a fixed rate while interest rates remain low, an ideal scenario but one not available to those underwater or with little equity.
Still, many banks are open to loan modifications, and may be willing to discuss this possibility before the loan resets and the borrower collapses into financial crisis.