Bob Piepergerdes, director of Retail Credit Risk for the Office of Comptroller of the Currency (OCC to you) has been sounding the alarm for a while, but his warnings have received scant media attention. What is he so worried about?
As you probably know, one of the reasons for the financial meltdown was that the mortgage payments families had to pay took large, sudden jumps when they adjusted upward, either because teaser rates expired, or the early interest-only periods phased out and borrowers had to start making fully amortized payments.
Well, there’s one more shoe to drop according to Mr. Piepergerdes, and I think he’s right. (Although it’s a smaller shoe.)
There were lots of Home Equity Lines of Credit (HELOCs) written in 2003 through 2007. I worked closely with a lot of financial planners who tend to love the product, so I wrote quite a few myself. I always made sure they were structured with low margins so they wouldn’t blow up if interest rates rose, but there was one thing I couldn’t help my clients avoid: equity lines all have a draw period, during which you can draw on the line as needed (up to the credit limit). During this time, your minimum payment would only be equal to the accrued interest., so you weren’t paying principal. (You could if you wanted, but naturally many folks have not.)
The draw period usually lasted 10 years. After that, you can no longer draw on the credit line and, if there is any balance at that time, you have to begin paying it off with amortized payments, usually over another 15 years.
Well, it’s ten years later, and there’s a lot of folks out there with legacy HELOCs whose draw periods are coming to an end. This means that if they’ve drawn money out to their maximum line and have been making interest-only payments (which describes a lot of them) their payments are about to jump.
How much? Let’s look at an example.
Let’s say I have a $100,000 equity line and I’ve tapped it out – I owe $100,000 against it. The interest rate is prime plus 0.500%. The Prime rate is at 3.25% today, so my interest rate is 3.25% + 0.500$ = 3.75%. My minimum payment is the interest that accrues each month, so my payment would be $100,000 x 3.275% / 12 = $312.50.
Now, I reach my ten year anniversary, and I have to pay off the remaining balance over the next 15 years. My minimum payment will be whatever it takes each month to amortize the loan over 15 years. It turns out that works out to $727.22. My payment just jumped from $312.50 to $727.22!
But we’re not done. HELOCs are invariably written with an adjustable rate tied to the Prime Rate. The Prime Rate tends to move when the Federal Reserve decides to move short-term interest rates, which they’ve pretty much said they will do in 2015 or before.
The Prime Rate, as we said, is currently at 3.25%, but an historical norm would put it at 6.000% or higher pretty easily. Let’s say that in 2015 the prime rate goes up to 5.25% just for the heck of it – and that isn’t out of the question.
Now, I’ll have to amortize that payment over the same time period but at 5.25% + 0.500% = 5.75%. My payment now would be $830.41.
You can see the problem. We’ve pretty much stabilized most of the market as far as first mortgages go, but there are millions of equity lines out there whose payments are about to go up by a factor of 2 ½ or more.
How big a problem is it? The OCC estimates that $171 billion worth of equity lines will reset between 2014 and 2018.
Just when you thought it was safe to go back in the water.
If you or someone you know has an equity line whose draw period is almost up, talk to me. I’ll you’re your paperwork to help you determine what you are facing, and what you can do about it.
My name is Casey Fleming, and I am a mortgage advisor in California based in Silicon Valley.
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