The agency that regulates Fannie Mae and Freddie Mac is considering reducing the maximum size of home loans that the mortgage giants can acquire. Above, Fannie Mae's headquarters in Washington. (Manuel Balce Ceneta / Associated Press)
That's because these credit lines, which are second mortgages with floating rates and flexible withdrawal terms, carry mandatory "resets" requiring borrowers to begin paying both principal and interest on their balances after 10 years. During the initial 10-year draw period, only interest payments are required.
But the difference between the interest-only and reset payments on these credit lines can be substantial — $500 to $600 or more per month in some cases. If borrowers cannot afford or choose not to make the fully amortizing payments that reduce the principal debt, the bank that owns the note can demand full payment and foreclose on the house if there is sufficient equity.
According to federal financial regulators, about $30 billion in home equity lines dating to 2004 are due for resets next year, $53 billion the following year and a staggering $111 billion in 2018. Amy Crews Cutts, chief economist for Equifax, one of the three national credit bureaus, calls this a looming "wave of disaster" because large numbers of borrowers will be unable to handle the higher payments. This will force banks to either foreclose, refinance the borrower or modify their loans.
But refinancings often will not be possible, Cutts says, because the homeowners won't qualify under the tougher mortgage rules taking effect in January, or the combined first and second mortgages may exceed the value of the house. Complicating matters further, interest rates are likely to rise from their current low levels as the Federal Reserve tapers its purchases of Treasury and mortgage-backed securities. Higher base rates would make the payment shocks even worse. Plus, according to Cutts, many of the owners with high-balance credit lines already have low credit scores — legacies of the housing bust and recession — and have an elevated statistical risk of default after the reset.
Financial regulators, including the comptroller of the currency, are aware of the coming bulge in high-risk resets and have been urging the biggest banks to set aside extra reserves for possible losses. Last month, Citigroup said it was increasing reserves on its nearly $20 billion in home equity lines and acknowledged that the reset payment shocks for borrowers could be a major challenge.
Rating agency Fitch has also sounded the alarm, warning that banks face "increasing credit risk" in 2014 and beyond as borrowers who took advantage of easy terms and fast-rising home values during the boom now confront much tougher credit conditions and could default.
What does all this mean for homeowners with boom-era credit lines and hefty unpaid balances? Potentially a lot. Check your credit line documents to determine when you're scheduled for a reset. Consider contacting the bank that owns your note and asking for an estimate of what your post-reset payment could amount to at your current principal balance or what it would be if you paid off some of the principal.
Most important, be aware of your options. If you have adequate equity in the house but are strapped for monthly cash, talk to the bank about a possible refinancing or loan modification that could lessen the payment pain. Since banks are being pressured by regulators to deal with their potential equity loan issues in advance, you might be able to come up with a modification solution acceptable to both you and the bank.
If you are underwater on your mortgage — more than 1 out of 7 owners continues to owe more on the mortgage than the home is worth, according to realty data firm CoreLogic — and you can't afford the reset payment, the bank may not foreclose on you because there's no equity to recover. But the bank could sell your charged-off account to a debt collection firm or even pursue you for a deficiency judgment in states where that is permitted.
Any failure to pay, however, would be bad news for your credit scores, says Equifax's Cutts — a "big negative" on your credit files, a blot that could cause you problems for years.
Bottom line: If you're one of the many owners with a boom-time credit line facing a reset, don't wait for trouble to happen. Start mapping out your strategy well in advance.