Consider the following:
Banks lure consumers into substantial loans in return for minor payments in the near-term. The loan payments eventually adjust to include both the interest and principal amount. Consumers lack the resources to cover the higher payments; a crisis is born.
Sound familiar? This scenario should evoke imagery of the subprime mortgage crisis of the mid-aughts; the same crisis that continues to reverberate to this day, but with a slightly different riff on this familiar theme.
Enter: the home equity line of credit.
Home equity lines of credit (or “HELOCs”) gained popularity during the housing bubble of the mid-2000s. As the housing market began to heat up and homeowners witnessed an unprecedented increase in home values, banks began to aggressively market a new opportunity for consumers to tap into this windfall in equity by using their homes basically as ATMs; allowing consumers to withdraw up to 100% of a home’s value. Consumers obliged, using HELOCs to finance both in- and out-of-house endeavors (e.g., home improvements, college tuition, and vacations).
The appeal of these loans is easy to understand. HELOCs gave borrowers access to large amounts of money to spend at their discretion and at relatively little cost upfront. Borrowers were typically allowed access to an open-ended account for a period of ten years – known as the “draw period” – and were only required to make payments on the accruing interest, rather than on the principal, of the credit line during that time. But the draw period has or is about to come to an end, and credit lines for millions of borrowers will reset to amortized loans that will now require payment toward a principal balance that has been left untouched. For example:
A homeowner who owes $100,000 on a HELOC carrying a 3.5% interest rate would see payments rise to $715 from $292 when the interest-only loan converts to a 15-year amortizing mortgage. If interest rates were to rise by three percentage points, payments would go up an additional $150.
Borrowers are certain to be shocked and incredulous at the sight of their recalculated payments, confident of a mistake on the bank’s behalf; a crude reminder that some borrowers have only paid interest for the last decade. This shock will reverberate throughout the country, but especially so in California, where the average HELOC written in 2004 and 2005 was for $150,000 and $139,000, respectively. Circumstances will be most dreadful for borrowers with HELOCs that require balloon payments after the interest-only period; they will owe the balance in full. This impending wave of HELOC resets could be a harbinger of financial disaster: the number of borrowers missing payments around the 10-year can double in the eleventh year, and borrowers on more than $220 billion of these loans (or roughly 40% of the total outstanding balance) will see their monthly payment jump between 2014 and 2017. Because home values were eviscerated as the market began to plummet, many homeowners will not have the equity necessary to refinance their HELOC into a burden more manageable.
This is poised to be yet another setback for consumers, who have been suffering through an ongoing economic malaise and years of stagnating wages. Many consumers can no longer afford to finance the purchase of life’s necessities on wages alone, but instead must increasingly borrow to mute the effects of flagging incomes – arguably, a catalyst to the proliferation of HELOCs and other financial products with low introductory rates during the early-to-mid-2000s. This wave of HELOC resets and attendant defaults will be an episode in the ongoing effort to squeeze water out of a stone, as consumers will be forced to dip further into their dwindling pool of resources in order to accommodate the higher payments.
Going forward, attention must be paid to a potentially troubling trend facilitated by a combination of consumers’ financial strain, disaster myopia and societal amnesia with respect to the bubble years that could metastasize into another financial downturn. Banks are once again offering to lend a helping hand to those struggling in this era of stagnation, and consumers in turn have begun to burden themselves with debt at a rate not seen since 2007. And yes, this includes HELOC originations, which hit $111 billion in 2013, with a year-over-year increase of 43% in the fourth quarter; “deep subprime” borrowers received HELOCs worth $60,000 on average.
Where this wave of HELOC resets and concurrent rise in consumer debt accumulation will lead is difficult to predict, but recent history advises against an overly sanguine outlook. If the subprime mortgage crisis taught us anything, it is this: easy money upfront can come at a debilitating cost on the backend. Let us just hope we have learned that lesson.
Photo credit: Pat (Cletch) Williams