Home Equity Lending: Growth and Innovation Alter the Risk Profile
As a component of the mortgage lending business, home equity lending has traditionally been characterized by low credit losses. However, recent trends reveal a rapidly changing landscape in the way that home equity lines of credit (HELOCs) are used by household borrowers and structured by mortgage lenders. Home equity debt is rapidly growing as a percentage of total household indebtedness, in part as a result of new loan programs that make HELOCs more accessible to borrowers, including groups of people who previously would not have had access to this product.

Amid these longer term changes in the marketplace, the current environment offers the additional challenges of rising short-term interest rates and the likelihood that home price gains will eventually level off in some of the nation's pricier home markets.¹ As a result of these trends, it is increasingly uncertain whether the traditionally low credit losses associated with home equity lending will remain a permanent attribute of this line of business. In any event, the changes being wrought by the marketplace are requiring both lenders and borrowers to think about home equity products in new ways. (See the inset box for information on HELOCs versus home equity loans.)

Home Equity Lending: HELOCs versus Home Equity Loans
Home equity lending comprises two types of loans secured by junior or senior liens on 1—4 family residential properties: (1) HELOC, an open-end, revolving credit that is typically tied to a variable interest rate and allows borrowing of any repaid loan amounts, and (2) home equity loan (HEL), a closed-end, one-time credit with fixed interest rate and repayment amounts. Table 1 shows that home equity lending as a whole is dominated by HELOCs, which compose almost 80 percent of market share. HELOCs also account for almost all of the recent growth in home equity lending, averaging 30 percent quarterly growth since 2000, while HELs have been relatively flat. Because of their high market share, soaring growth, and exposure to interest rate risk, HELOCs are the focus of this article.

Table 1

Chart 1
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Recently, preference by households for mortgage debt has become even more pronounced. Since the end of 2000, total mortgage debt owed by households has soared by $2.25 trillion, or 47 percent. Two principal factors account for this recent increase in mortgage indebtedness: a rapid accumulation of owners' equity in residential real estate and a sustained decline in mortgage rates to historic lows.

The equity held by U.S. households in their homes has also risen sharply of late (by almost $2.2 trillion since 2000) as homeownership has spread and home prices have surged. The percentage of U.S. households that own their own homes reached a record high of 69.3 percent in second quarter 2004, reflecting the addition of more than 12 million new homeowner households in the past ten years. This increased demand for housing, in turn, has helped push home prices higher. The repeat-sale home price index of the Office of Federal Housing Enterprise Oversight (OFHEO) rose by nearly one-third from 2000 to 2003, and none of the 331 individual U.S. metropolitan areas covered by the OFHEO index has seen an annual price decline since 2000.

As home prices have surged, home construction has remained brisk. The annual number of new homes started has exceeded 1.5 million units in every year since 2000, rising steadily during that time to an 18-year high of 1.85 million units in 2003.

Sustained low mortgage interest rates have provided the backdrop for rising mortgage indebtedness, rising home prices, and rapid home construction. An industry standard measure of mortgage rates is the Freddie Mac contract rate for 30-year conventional mortgages. Between the inception of this series in 1971 and mid-2002, the Freddie Mac contract rate had never dipped below 6.5 percent. However, this rate has remained below 6.5 percent in every month since June 2002, dipping briefly to an all-time low of 5.23 percent in June 2003.

Such historically low mortgage rates not only have prompted households to take on mortgage debt to buy new homes but have spurred record volumes of mortgage refinancing. Homeowners have taken advantage of historically low interest rates to consolidate mortgages and refinance at lower rates, often taking cash out. The Mortgage Bankers Association (MBA) Mortgage Refinance Index climbed to all-time records in 2001, 2002, and 2003. As mortgage rates bottomed out, refinancing volumes peaked in June 2003, but they have fallen sharply since then. From June 2003 to June 2004, 30-year fixed mortgage rates increased more than 100 basis points, and the MBA refinance index dropped to its lowest point in two years. Indeed, the MBA recently forecast that the dollar volume of refinancings would decline 57 percent in 2004 from a record $2.5 trillion in 2003.²

Chart 2
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The rationale for homeowners' greater use of HELOCs is straightforward. With consumer spending outpacing income growth in the 2000s, homeowners have turned increasingly to home equity lending as a substitute for consumer credit to finance new consumption, reduce outstanding debt, or purchase a home in a two-loan package deal.³ The appeal over other more costly credit alternatives derives from the significant advantages of comparatively low interest rates, tax deductibility, and easy availability, since income and cash flow tests matter less for determining credit lines than for credit cards or auto loans. Furthermore, because HELOCs offer the flexibility to draw money only as needed and the convenience of a revolving credit line, borrowers favor HELOCs more and more over closed-end home equity loans.⁴ For these reasons, many homeowners are converting the equity in their home into cash through home equity borrowing and making this kind of transaction an increasingly important part of their household finances. With the dramatic decline in mortgage refinancing volumes since mid-2003, a homeowner would more likely choose to tap home equity through a draw on a HELOC rather than extract cash as part of a refinancing.

A rising volume of HELOC debt also has a rationale from the lender's perspective. Mortgage lenders are looking to home equity products to replace loan volumes that have declined in the wake of the refinancing boom. According to America's Community Bankers' 2004 Real Estate Lending Survey, 56 percent of survey respondents expected single-family residential loan production to decline this year as the refinancing boom slows; however, by a larger margin (64 percent), they expected an increase in home equity lending (see Chart 3).⁵ Clearly, lenders anticipate that consumers will turn more to home equity lending as refinancing activity wanes.

Chart 3
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The challenge for lenders in this post-refinance period is not only to lift production of new HELOCs but also to get customers to draw more against existing lines. Although HELOC outstandings totaled $415.8 billion in second quarter 2004, this represented only half of the total approved borrowing limits, or commitments, on those lines. The utilization rate for HELOCs was almost 49 percent as of second quarter 2004, leaving $435 billion sitting untapped in committed home equity lines extended by banks (see Chart 4). This untapped amount represents a substantial source of potential fee income for lenders and available cash for consumers.

Chart 4
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New Incentives to Boost Home Equity Borrowing
In addition to offering low introductory teaser rates common with many adjustable-rate credit products, lenders have an array of innovative products, marketing techniques, and sales incentives to attract new HELOC borrowers and encourage increased draws by existing borrowers (see Table 2). The objectives underlying lenders' efforts to increase home equity lending are to obtain new borrowers (for whom borrowing cash by tapping into their home's equity with a cash-out refinancing becomes more costly and less appealing as rates rise) and to encourage existing HELOC borrowers to draw down their unused commitments.

Table 2

Not only are many of these structures floating-rate products and thus exposed to rising interest rates, but many also have a loss experience that has been untested by a general downturn in the housing market. For example, interest-only loans often require a balloon, or lump-sum, payment when the term of the loan ends. Home equity disclosures do not require the creditor to disclose the amount of any balloon payment that will result under the terms of the plan. In addition, payments on some loans may not cover the interest due so negative amortization will occur, resulting in the loan balance increasing rather than decreasing and the borrower repaying a much larger loan amount in the long run. Lenders who extend HELOCs with a credit limit that automatically increases as the home appreciates or a credit line based on future value are gambling that home prices will continue to increase. Finally, HELOC borrowers who increase their draws may not be aware that the higher their use of this revolving line of credit, the more it negatively affects their credit score.

Underwriting Practices for HELOCs
The fact that HELOC credit losses have remained low and stable over time can be attributed largely to underwriting practices that evaluate borrowers effectively and provide the lender protections against default. Like other areas of consumer and mortgage finance, HELOC underwriting typically is based on quantitative credit models that relate credit scores and other criteria to a probability of default. While these models are by no means perfect, they offer lenders considerable insight into how well actual loan performance compares with model-based predictions. Stability in loan performance also has been greatly enhanced by the fact that HELOCs are secured by the equity in the borrower's home. Depending on the loan-to-value ratio of the credit, the presence of collateral may not offer a significant source of recovery to the lender in the case of default. Even when this is the case, however, the prospect of losing one's home remains a powerful deterrent against default.

Because of the tremendous growth of HELOC lending in recent years, concern has arisen that home equity underwriting practices have eased. Indeed, home equity products exhibited the greatest increase in risk, according to the 2003 Survey of Credit Underwriting Practices conducted by the Office of the Comptroller of the Currency (OCC). Although the performance of home equity loans remains strong, as demonstrated by low delinquency rates, the survey noted that "banks need to be alert to the risks that are introduced when high growth is coupled with liberalized underwriting."⁶

The OCC's reference to liberalized underwriting methods may allude to underwriting methods that are increasingly used by home equity lenders but may carry certain modeling risk due to the absence of a significant housing market downturn in over a decade and a mild recession in 2001. In 2003, 44 percent of lenders used auto-decisioning (defined as systematic credit decisioning with no manual intervention) in support of credit underwriting, up from 13 percent in 1999, and 84 percent used credit scoring, up from 68 percent in 1999.⁷

Lenders should be especially cognizant of underwriting practices during a period of change in the macroeconomic environment. The two biggest issues here that bring up questions are interest rates and home prices. Specifically, how fast and how far will interest rates rise during the present period of tightening monetary policy? Also, when will home prices ultimately level off, and could they actually decline in certain high-priced metropolitan areas? Because HELOC interest rates are typically tied to benchmark short-term interest rates, rising rates make it more expensive for borrowers to service their debt. Higher rates could also dampen demand on the part of new homebuyers, thereby slowing the rate of home price increases. Should home prices stagnate or fall, the most important effect for lenders could well be an erosion in the equity position of some homeowners that will marginally reduce their incentive to repay the HELOC.

Lenders should also be aware of HELOC use. Drawdown rates for HELOCs are edging up, from 44.4 percent in first quarter 2000 to 48.3 percent in first quarter 2004. However, these utilization rates remain well below the peak of 60.7 percent reached in first quarter 1991. The utilization rate is an important metric for lenders to watch, because a rise could indicate that consumers are drawing more on HELOCs for spendable cash and are in a weaker position to repay the loans.

Credit Performance Remains Strong...
To date, loan delinquencies have remained at historically low levels due to strong housing market fundamentals and low interest rates. In the area of home equity lending, such trends are even more pronounced. As home equity lending has soared in the past five years, more than doubling its share of total loans in bank portfolios, its credit performance has shown consistent improvement. The proportion of delinquent to total HELOCs was at 0.51 percent in second quarter 2004 (see Chart 5). This was the second lowest delinquency rate for all major loan categories, just behind multifamily properties at 0.53 percent, and far below 1.70 percent for all loans and leases.

Chart 5
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...But Most Loans Are New
The rapid increase in new loans, however, has shortened the seasoning of home equity pools, or their collective "age." The weighted average seasoning of home equity pools has declined considerably, according to Moody's Investors Service quarterly home equity index. Seasoning had shortened to just 15.89 months as of second quarter 2004 (see Chart 6). Loans typically move into their peak period of delinquency risk at around 36 months of age.⁸ Thus, the improving loan performance of HELOCs may merely reflect the fact that home equity loans are highly unseasoned. This situation may mask any potential increase in credit risk arising from the more aggressive loan structures introduced in recent years.

Chart 6
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Subprime Borrowers Present Credit Concerns
Credit quality concerns are most pronounced in the case of subprime households. Among subprime HELOC borrowers, delinquencies were high at 5.43 percent in second quarter 2004, compared with only 0.51 percent for overall HELOC borrowers (see Chart 7). Rising interest rates may well propel this rate higher, particularly since lower income households, whose incomes may already be strained, account for the highest proportion of subprime home equity borrowers.⁹

Chart 7
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Risk Management Considerations
Home equity lines account for a still small, but rapidly increasing, portion of the loan portfolios of FDIC-insured institutions. Despite the continued low credit losses that lenders are experiencing in these portfolios, changes in the marketplace are raising some concerns about future credit quality trends. Outstanding balances continue to rise rapidly as homeowners take advantage of increases in their home equity and historically low interest rates. Lenders, in turn, have targeted HELOCs as a new growth area in the aftermath of the refinancing boom. To further increase loan originations in the home equity lending area, lenders are using a number of new marketing techniques and loan structures with which they have comparatively limited experience to date.

Although the underwriting techniques typically applied to HELOC loans make good use of available quantitative data and modeling techniques, there is evidence that risks are rising. Besides rapid growth and new lending techniques, a changing macroeconomic environment also poses challenges. The recent period of historically low interest rates and rapidly increasing home prices was particularly conducive to the use of HELOC credit by homeowners and to their ability to service that debt. However, to the extent that these conditions give way to a period of higher interest rates and stable or falling home prices, loan performance could deteriorate in the future. Uncertainty about future loan performance is heightened by the fact that HELOC portfolios remain highly unseasoned at present. Given these uncertainties, lenders and borrowers should not automatically assume that their historical loss experience is an accurate guide to future repayment ability. To the extent possible, it makes sense in this environment to estimate how loss projections might change under a less advantageous set of market conditions.

Cynthia Angell, Senior Financial Economist

¹ See "A Turning Point Ahead? National and Regional Trends in Residential Real Estate Markets" in this issue.

² Mortgage Bankers Association, "MBA Mortgage Finance Forecast," August 13, 2004.

³ A home purchase can be transacted with a two-loan package deal, or piggyback loan, wherein a buyer typically makes a 10 percent cash down payment and finances the rest with a first-lien mortgage of 80 percent and a home equity loan for the remaining 10 percent. Borrowers who typically use piggyback loans may be financially stretched and unable to pay a 20 percent cash down payment, want to sidestep private mortgage insurance premiums, or wish to avoid a jumbo-rate first mortgage.

⁴ HELOCs led home equity loans with 79 percent of market share as of June 2004 (see Table 1).

⁵ The results of the America's Community Bankers' 2004 Real Estate Lending Survey correspond with those of the Office of the Comptroller of the Currency's 2003 Survey of Credit Underwriting Practices (see note 6), which reported that home equity lending has grown tremendously in recent years and that many banks plan to continue to increase this product over the next year.

⁶ Office of the Comptroller of the Currency, 2003 Survey of Credit Underwriting Practices, September 2003, http://www.occ.treas.gov/2003underwriting/creditunderwriting2003.htm.

⁷ Consumer Bankers Association, 2003 Home Equity Study, November 2003.

⁸ National Mortgage News, October 29, 2001, citing Moody's Investors Service.

⁹ Edward M. Gramlich, "Subprime Mortgage Lending: Benefits, Costs, and Challenges," at the Financial Services Roundtable Annual Housing Policy Meeting, Chicago, Illinois, Federal Reserve, May 21, 2004.