Managing Your Home Equity Loan
by Broderick Perkins
There's probably no better time than the present to pull your credit report and scrutinize your creditworthiness, especially if you are considering a home equity loan. If you already have an equity loan, read the small print. What's more, you may want to seek a professional to help guide you through what could be a shift away from the easy money that's helped fuel the housing boom in recent years. More border-line borrowers could find applications for second mortgages declined and those who hold equity loans could find their lines of credit frozen or even canceled if their payment habits become questionable. "If you are depending on a home equity loan and that is suddenly taken away it could cause you to lose your home," said Cindy Marcus, RE/MAX Santa Barbara, Montecito, Goleta, CA. It's not yet clear how lenders will react, but federal monetary system regulators have issued guidelines that effectively tell lenders to tighten lending practices which, over the years, may have become too lax. The Feds are particularly concerned about lenders' portfolios that are heavy with riskier home equity lines of credit loans (HELOC), including interest-only loans, loans with higher loan-to-value (LTV) and debt-to-income ratios, loans approved for borrowers with lower credit scores, loans secured with questionable appraisal methods, and so called "no-doc" loans written without documenting a borrower's assets, employment and income. Those kinds of loans have become more and more popular to help borrowers afford to buy homes in the over-heated housing market of escalating prices. Why the concern? Here's the scoop and what you should do to deal with it. Coinciding with heightened concerns about escalating home prices, industry fraud, the potential for higher interest rates and other issues that could factor into a housing market bubble bust, the Federal Reserve, along with the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the National Credit Union Administration, recently issued "Credit Risk Management Guidance For Home Equity Lending." The guidelines tell lenders to: - Periodically refresh credit risk scores on all customers.
- Use behavioral scoring and borrower characteristics analysis to identify potential problem accounts.
- Periodically assess payment patterns, especially borrowers who make only minimum payments over a period of time or those who use the line of credit to make payments on the line of credit.
- Obtain updated information on a home's value when significant market factors indicate a potential decline in home values, or when the borrower's payment performance deteriorates and there's a greater reliance upon the home as collateral.
"The Feds are saying ... these home equity products are going to experience high default rates that will trigger many more workouts and foreclosures. Workouts will devalue the investor's portfolio, and foreclosures will be costly. Where there is appraisal fraud, the collateral may not cover the debt obligation and there will be write-downs and capital expenses associated with the collection effort," said Marie McDonnell, The Mortgage Counselor in Orleans, MA. "In addition, lenders and servicers will have to increase their capital reserves to accommodate the fallout and this will put many of them on the brink of ruin," she added. That could mean borrowers will have to maintain their financial and credit standing atleast at levels achieved when the home equity loan was originally approved. Some home equity borrowers may already be in trouble, especially if their loan's rate is tied to the prime. The most widely quoted prime rate, the Wall Street Journal prime rate, is a consensus prime rate based on the prime rate offered by 75 percent of the nation's 30 largest banks. It moves in lock step with changes to the benchmark federal funds rate set by the Federal Reserve. In the past year, the feds have increased the benchmark rate eight times and the prime has followed, moving two full percentage points from 4 percent last June (the lowest level since 1958) to 6 percent this May. What's a borrower to do? "Right now prime is at 6 percent. Many people who hold equity lines are around prime plus 0 percent. Most fixed rate second are at about 7.5 percent which leaves a spread of 1.5 percent (6 more 1/4 point federal rate hikes). But there are down sides to keeping an equity line and there are lower fixed rate programs if borrowers qualify," said Stephanie Noryko, a mortgage broker with Granite Financial Home equity is the difference between your mortgage balance and the value of your home. New England's Eric Tyson, a personal finance counselor and author of several real estate "Dummies" guides, says your home equity is not collateral for frivolous expenditures. Any loan tied to your home's equity is by nature an equity-depleting loan and the bestuse of equity money is for capital improvements and investments that provide an equal or better return on your money than the cost of the loan. Home improvements, education for the kids and new business financing are relatively better uses of equity than buying cars and boats and vacation. Debt consolidation and emergency nest eggs can be other wise uses, provided those uses don't become habits. "The answer is always to structure out risk," says McDonnell. "The first thing that I advise is for consumers to begin building up six months of mortgage payments in their savings accounts to handle the ups and downs of the market and to prepare for life's unexpected vicissitudes. For consumers who do not need the flexibility of their home equity revolving line of credit, they may want to refinance to a fixed rate second mortgage, even if the rate is a little higher," said McDonnell. Chances are, as the Fed continues to raise benchmark rates and prime rates, equity loan rates tied to the prime will likewise continue to rise. "If consumers have enough disposable income, by all means, accelerate the payoff of the loan by making principal curtailment payments. However, consumers should not be duped into paying off an underlying first mortgage that has a nice low fixed rate in order to consolidate debt," said McDonnell. Noryko suggests calling in an expert. "There is no one answer for everyone. It must be analyzed on a case-by-case basis. My suggestion is to call periodically to analyze the alternatives," she said. Noryko said while the advantage to an interest-only loan is the smaller payment, the down side is that if the interest only payment is made month after month, the original loan balance remains the same. An expert can determine if a borrower has enough increased home value to obtain a new first mortgage to cover both the current first and second with a more favorable, affordable rate without private mortgage insurance or pay off penalties. How long the borrower plans to stay in the home can also be factored into the cost of refinancing to deal with exposure to the risk of higher monthly payments. "I like to look at their payment exposure to interest rates increasing," said Brandon Knapp, a mortgage planner with Lawson & Associates Mortgage Planners in Campbell, CA. "If their loan amount is small, then the flexibility of the HELOC might be better than a fixed rate. For example, on a $50,000 HELOC, the payment only increases by about $42 a month for every 1 percent increase in the interest rate. On a $200,000 HELOC the payment increases $167 month for each 1 percent increase in the rate. A home equity loan (fixed) rate is usually at least 1.5 to 2 percent higher, so how high does the prime rate have to go before the client pays more for the loan? A home equity loan payment on a $50,000 loan is $100 or more higher than the HELOC," Knapp said. | 
