Wells Fargo (NYSE:WFC) announced Thursday that it will no longer be accepting applications for home equity lines of credit, or HELOCs.
This is the latest move by a major U.S. financial institution to tighten its mortgage lending practices. JPMorgan Chase (NYSE:JPM) has previously announced that it would stop approving new HELOCs, and also announced tighter credit standards for new mortgage customers.
This isn't exactly surprising. Recessions tend to lead to an uptick in loan defaults, and borrowers in the lower credit tiers tend to fall delinquent in greater numbers during tough times. In response to economic downturns, it isn't uncommon for banks to back away from loans they perceive as risky. We said this during the 2008-09 financial crisis, and for several years after.
Why are banks backing away from HELOCs?
A home equity line of credit, or HELOC, allows a homeowner to obtain a line of credit backed by the equity in their home. If a lender uses a 80% loan-to-value ratio (the most common), and you owe $100,000 on a home worth $200,000, you might be able to get a HELOC for a maximum of $60,000. ($160,000 is 80% of $200,000).
From a bank's perspective, a HELOC is a far riskier loan than a mortgage, even for borrowers with top-notch credit standards.
The reason? A HELOC is in a second-lien position. If a borrower defaults on their mortgage and HELOC and the home is foreclosed upon, the mortgage lender gets to recoup the money owed to it before the HELOC lender can get anything. In a market where real estate prices could potentially decline (like a deep recession), it becomes a real possibility that a HELOC lender could end up with a big loss.
To be clear, both Wells Fargo and JPMorgan Chase are still making cash-out refinancing loans, which also allow borrowers to tap into their equity. But for the foreseeable future, it looks like HELOCs will be increasingly difficult to find.