The Security of Home Equity Lines of Credit, Research Paper Example

Introduction

There are various means for the US citizens to get a loan, and various guarantees for the return of the loan are used in the financial system. If the citizen secures the loan he/she takes by the house, this is called a mortgage. Usage of mortgages is widely spread in the USA because it provides the population with considerable long-term loans that can be used for education or any other purposes (Guttentag). However, there is an alternative to a standard mortgage available for those who have a house. It is called Home Equity Line of Credit or HELOC for short. It is usually used as a second mortgage, available even for those who have already secured their loans by their property.

It has a set of distinguishing peculiarities that may be beneficial for some users. When using a standard mortgage, the loaner is able to get the whole sum of money on the mortgage and treat it the way he/she chooses. In case of applying for a HELOC, the loaner will get the opportunity for borrowing money up to a certain amount, with an ability of taking it from a credit card, or using it with checks etc. (Guttentag). Such convenience of having money at one’s disposal has surely attracted many US citizens, which can explain the HELOC boom in 2000s. The rate of HELOC applications was really high for several reasons.

First of all, repayments on HELOC are tax-deductible, and taking into consideration the tax reform that took place in 2000s many citizens recognized the benefits of HELOC (Orman 107). Secondly, the perspective of spending money only in case the need occurs and always having a substantial sum of money on one’s credit card appeared very attractive for many citizens, especially because of the long draw period when they had to pay only interest, and much longer repayment periods that took about 15-20 years and allowed the possessors of HELOC gather funds to repay the loan (Guttentag).

Partly HELOC contributed to the worsening position of the US population at the period of the global economic crisis, which was attributed to its specific features. Despite the fact that HELOC offers many comparative advantages for people needing a secured loan, it also conceals some significant drawbacks that are not seen in the periods of welfare but become vital in the time of crisis. The HELOC popularity resulted in a dramatic rate of foreclosures in 2007-2009, so the causes for such a financial drama should be examined much closer. The aim of the present paper is to understand advantages and risks that HELOC has and to identify the way structured finance affected so many people in the period of crisis.

Advantages of HELOC

The first advantage of HELOC that attracted so many users was the particular system of counting interest that differed greatly from the usual interest calculation on a mortgage. A regular mortgage was treated on a monthly basis, and the annual interest rate was divided into twelve months, thus making each monthly payment equal. However, HELOC used another system of calculation:

“Because the balance of a HELOC may change from day to day, depending on draws and repayments, interest on a HELOC is calculated daily rather than monthly. On a 6% HELOC, interest for a day is .06 divided by 365 or .000164, which is multiplied by the average daily balance during the month” (Guttentag).

Though such benefits revealed themselves only in the short term, still they showed assessable advantages for some US citizens and ensured the popularity of HELOC. Secondly, HELOC showed great advantages to fund intermittent needs as the user would have to pay interest only on the amount of money he/she used, not having to repay the whole sum interest. In case people used not all money, or used it thoughtfully, the amount of repayment would be much lower in comparison with a standard mortgage (Guttentag). Thirdly, the settlement costs for HELOC are more than twice as low as the ones for a mortgage, which also provides their attractiveness and popularity. Finally, some types of HELOC are convertible into fixed-rate loans in the draw period (Guttentag).

Among other advantages of HELOC one should remember that no home loan appraisal or closing costs must be paid, no HELOC account maintenance or check-writing fees are deducted, unrestricted ability to repay principal without penalty can be granted to the user (HELOC – Home Equity Line of Credit). These benefits offered to HELOC users suppose a clear benefit both in the short and in the long run. Nonetheless, all benefits will be usable only in case the possessor of HELOC utilizes the funds got from the loan wisely and remembers about the fact that money has to be returned in due time and in full. In case there is no confidence in the outcome, it is better to consider the risks HELOC presupposes and to rethink the opportunity for applying for it.

Risks Related to HELOC and the Financial Crisis of 2000s

Alongside with many benefits HELOC offers to its users, there is a set of dangers it conceals. The main threat is the economic instability – regular loans and mortgages have fixed rates, so the applicant should not worry about raising interest rates. Thus, in case an individual gets a fixed-rate loan, he/she may be urged to pay more for the loan, but still the rates will not rise in case the crisis awaits the national economy. HELOC attracted US citizens because they experienced a short tax break, with rates being at the record low in 2000s. Most of HELOC applicants did not suppose that in several years the global financial crisis would occur, so they could not expect the interest rates to rise that high (Orman 107).

In addition, some of HELOC recipients decided to refinance their credit card loans with HELOC funds, which was a grave mistake. A credit card loan is unsecured, so in case the possessor does not pay off the card debt he/she will not suffer any foreclosure. But in case the mortgage or HELOC is not paid off, one’s home becomes the collateral of the debt, so the creditor can ask the loaner to sell his/her property to pay off debts at any time (Orman 134). Here is in what situation the HELOC possessors found themselves as soon as the crisis broke out and they were urged to pay off their credit debts (in case the home actually cost $90,000 and was overestimated for $110,000 to get HELOC of $30,000):

“Now you have $30,000 and live the life for awhile, perhaps a new boat, car or vacation. Then comes the day you need to sell your home but it’s only worth $90,000 and you need $110,000 plus the realtor fee of $7,700 (7%), so you put the house on the market for $117,700 and it never sells, payments become late and worse case scenario, you have a foreclosure  on your hands!” (HELOC – Home Equity Line of Credit).

This is a dead end in which tremendous numbers of the US citizens faced during the economic crisis. The mechanism of structured finance is used to secure the risks on the assets of the population, opening alternative sources of funding their needs. Mortgages, second mortgages, second loans – all these tools were designed to help the population realize their ambitions and provide for their living, ensuring payoffs in the long run. This system really worked successfully at the beginning of the third millennium and ensured the boom of crediting and mortgaging as people of the United Stated experienced the unrivaled welfare and stability. Nonetheless, the system revealed its drawbacks very soon and seriously contributed to the economic and financial crisis in the USA and worldwide. Funds the state granted to the US population were returned at a slow pace, disabling the economy that turned out to lack financial resources. As soon as the crisis broke out, people were massively laid off, becoming unable to pay off the credit debt they expected to earn at their works that they suddenly lost. The problem became complex – the government had no more opportunity to secure the funds of population, so financial institutions that had granted HELOC were urged to initiate foreclosures to stay afloat. As a result, many people lost their homes being unable to conduct repayment.

There are hundreds of sad stories about foreclosures that occurred throughout the USA for the period from 2007 to 2009. Washington Mutual is one of the biggest issuers of second mortgages in the USA, and it reacted in the corresponding way to the threat of non-repayments in 2008. The news were striking for equity line owners in 2008 – WaMu announced the reduction and suspension of $6 billion of available funds that were given to individuals on HELOC (Tedeshi). The company commented its decision the following way: they had reacted to the negative tendency of repayment, witnessing bad home equity loans in Seattle only equaling $1.1 billion (which was 35% higher than previous year) (WaMu reduces home equity credit to homeowners). They also explained this action as a reaction to the $9.2 billion of nonperforming assets, which constituted about 2.9% of total assets of the company (WaMu reduces home equity credit to homeowners).

The measures had a dramatic effect on HELOC users because the company also announced constant re-evaluation of the property that was the collateral on HELOC. Since the prices of houses nosedived during the first year of the crisis, people who had HELOC were deprived of the opportunity to sell their houses and to pay off their debts – the houses still cost less than their HELOC debt was. Declining credit score was only one of the slightest effects of suspension and reduction of HELOC funding facilities – in case people experienced an overdraft on the newly established credit scores, they were penalized (Tedeshi). The complex negative impact on the financial situation of HELOC holders was evident shortly after these measures that were followed by Bank of America and JP Morgan Chase in 2008 and by many other users later on (WaMu reduces home equity credit to homeowners).

Conclusion

As one can see, HELOC is a highly beneficial credit line for people who already have mortgages but still need funds for some purposes, for example paying for tuition etc. The advantages HELOC promises are visual in the short term and in the periods of economic stability. The interest rate on HELOC is tax-deductible and appears highly profitable when state taxes are low (which was evident in the USA in the early 2000s). However, as soon as the crisis occurred in the USA, all possessors of HELOC experienced the hidden threats it possessed. The major trouble for most people who faced the foreclosure was that HELOC was the second mortgage, so in any case, failing either the first one or HELOC, they had to sell their houses.

The second trouble was that foreclosures were accompanied with massive layoffs, making people simply unable to pay off their debts or at least hoping to do this in the near future. Large-scale unemployment was aggravated by the fact that it was unexpected, so people did not have a chance to restrict their expenditures or plan their savings to protect their families and homes. The structured finance system in the USA failed to secure its users, which was highly evident in the sphere of mortgages and HELOC.

To crown it all, the heavy impact that possessors of HELOC experienced was the considerable increase in taxes. So, in addition to the financial burden that was laid on the US population due to the unemployment increase, interest rates on HELOC raised, in contrast to fixed-rate loans that remained comparatively bearable. Consequently, HELOC enrollees found themselves in the situation of having no money to pay off the interest rates, and simultaneous rise of the loan, which was a situation hardly anyone would have handled. This crisis in the structured finance sector and the private sector revealed all risks and threats HELOC had and resulted in large-scale foreclosures, leaving thousands of people without shelter in the hard period for the US economy and nation.

Works Cited

Guttentag, Jack. ‘What Is a HELOC?’. The Mortgage Professor’s Web Site. 2010. 5 May 2010. <http://www.mtgprofessor.com/a%20-%20second%20mortgages/ what_is_a_heloc.htm>

‘HELOC – Home Equity Line of Credit’. 2010. 5 May 2010. <http://www.auditmypc.c om/heloc.asp>

Orman, Suze. The money book for the young, fabulous & broke. Riverhead Books, 2005.

Tedeshi, Bob. ‘Shrinking Lines of Credit’. The New York Times. 2008. 5 May 2010. <http://www.nytimes.com/2008/06/08/realestate/08mort.html?_r=1&ref=business>

‘WaMu reduces home equity credit to homeowners’. Wichita Business Journal. 2008. 5 May 2010. <http://www.bizjournals.com/wichita/stories/2008/05/12/daily 50.html>