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Why Many Homeowners Face Risk of Default

Before the housing market collapsed, homeowners commonly accessed the equity they had built up in their houses with a home equity line of credit, or HELOC. Now some credit experts warn that the reset of those HELOCs could cause a new wave of financial distress.

A new study by TransUnion found that 16 million American homeowners have a collective $474 billion in HELOC balances, and 52% of these HELOCs have a balance of $100,000 or more. Unnervingly, the researchers also found that $50 billion to $79 billion of those balances could be at "elevated" risk of default in the next few years.

The risk of default owes to the structure of HELOCs, which are second mortgages with variable interest rates and a split repayment schedule. HELOCs have an initial draw period -- usually 10 years in duration but sometimes as long as 20 years -- during which the borrower makes interest-only payments. At the end of the draw period, the borrower must begin repaying both principal and interest, which can nearly double the monthly payment. Payment shock can be particularly harsh for borrowers with a high balance, especially if interest rates increase.

Nearly half of all HELOCs with a current balance were originated between 2005 and 2007. As most of those lines of credit have a 10-year draw period, the adjustment to full payments will hit beginning in 2015 and continue into 2017.

HELOC default risk
TransUnion's findings, based on the credit scores of consumers with HELOCs and an analysis of whether those consumers will have sufficient cash flow to absorb the payment shock, showed that less than 20% of borrowers are at risk of a default, which could eventually result in foreclosure. However, borrowers with sufficient home equity have more options to refinance or sell their home in order to repay the HELOC, as well as their first mortgage.

If you can't make the higher HELOC payments after your line of credit resets, and your home doesn't have enough equity, your lender may choose not to pursue a foreclosure, as there wouldn't be any equity to collect. However, don't think that means you're off the hook for the debt: Your lender could send the HELOC balance to a debt collector or sue you for the deficiency balance, if that is allowed by law in your state. Regardless of how your lender handles the issue, your credit will be damaged if you fail to make full, on-time payments on your HELOC.

HELOC reset payment estimates
A consumer who has a HELOC with a 10-year draw period and a 20-year repayment period at 4% could expect the following payment shock when their line of credit resets:

Balance Interest-Only Payment Principal and Interest Payment
$20,000 $67 $121
$50,000 $167 $303
$100,000 $333 $606

Two factors that will influence the size of payments on a HELOC are the variable interest rate and whether you have made payments to lower the principal balance during the interest-only period. Some financial experts are concerned that the payment shock will be worse for HELOC borrowers in the coming years because interest rates are anticipated to rise. But borrowers who have been paying down the principal on these lines of credit will obviously have less to repay over time.

HELOC reset options
If you're concerned about your HELOC resetting, there are several steps you can take immediately:

  • Check your HELOC paperwork to find out when your loan resets and ask your lender for an estimate of your payments after the reset.
  • Some lenders offer HELOC borrowers the option of converting their variable-rate line of credit to a fixed-rate loan. Ask your lender if this is a possibility for your HELOC.
  • If you have time before the reset, try to pay extra on the principal to reduce your balance.

Once you have a better idea of what you're facing, you can investigate options for refinancing.

If you don't have enough home equity to refinance and are concerned that you won't be able to make the loan payments, contact your lender immediately to see if a loan modification is an option.

If you have 10% or more in home equity, consider the following choices:

  • Refinance your HELOC and your first mortgage into one fixed-rate loan. If you can afford the payments, consider shortening your loan term to a 15- or 20-year loan so that you pay off your mortgage faster, build equity more quickly, and lower the amount of interest you'll pay over the life of the loan.
  • Refinance your HELOC with a new HELOC. Be aware, though, that while this postpones your repayment and allows you to once again pay only interest during the draw period, interest rates appear likely to increase. Your delayed repayment could require higher interest rates and a bigger total outlay in interest payments.
  • Take out a home equity loan to pay off your HELOC balance. Your closing costs will be lower if you choose this option instead of refinancing, but your interest rate will be higher than the rate on a first mortgage.

If you haven't refinanced in years, be prepared to do some rigorous documentation of your income, assets, credit score, and debt-to-income ratio, as well as a new appraisal of your home value. Lenders are less willing to allow homeowners to borrow heavily against their home equity because they're more aware than ever that falling home values have serious consequences for borrowers with low equity. If you have a HELOC on your personal balance sheet, investigate your future payments and your options as soon as possible to give yourself more time to strategize for a new financial scenario. 

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