Home equity lines of credit (HELOC) borrowers are about to collide with reality as the initial interest period expires for many of these loans. To date, many borrowers who took out HELOCs during the Millennium Boom have made only minimal payments, covering interest, but not reducing the principal balance of their loans.

Between 2014 and 2017, 60% of all HELOCs will start requiring principal payments, according the Office of the Comptroller of the Currency. By 2018, $111 billion of existing HELOCs will switch to include principal payments in addition to interest.

Borrowers will find themselves in a tight place since many of the junior liens originated during the boom were adjustable rate mortgages (ARMs). Further, because property values have plummeted since the origination of these HELOCs and a majority of loan modification programs leave second mortgages untouched, refinancing the loans under better terms is impossible for many borrowers.

According to Amherst Securities, the nation’s widespread negative equity could be significantly mitigated if HELOCs were cut or simply forgiven similar to modification programs designed for first mortgages, such as the Home Affordable Modification Program (HAMP). For example, the Second Lien Modification Program (2MP) addresses HELOCs, simultaneously modifying both senior and junior liens on homes.

first tuesday take

In perhaps the most vivid example of “burning the candle at both ends,” masses of California homeowners took out HELOCs on their homes during the Millennium Boom, using 40-50% of these funds to finance luxury consumer items like new cars and lavish vacations. Borrowers became dizzy with their ability to buy a home with no money down, then pay for home improvements with no money down, then buy a car with no money down, building a precarious tower of lender-directed IOUs, which today continues to crash.

Related articles:

The effect of home equity borrowing on the real estate market bust

Home equity to remain tight through 2010

However, HELOC borrowers were not the only ones responsible for burning-out the light of the housing market. Lenders and the federal government held their own matches to the wick. Lenders originated these risky junior liens and the U.S. government patted HELOC borrowers on the back by offering tax deductions for interest on personal consumption loans.

Now that the afterglow of the initial draw periods for these loans is dimming, agents can expect an increase in defaults and foreclosures to follow. A study by professors from the University of Chicago Booth School of Business attributes 45% of national home loan defaults from 2002-2009 to home equity-based borrowing. However, once the upcoming mass of foreclosures is purged, the market can start its recovery process.

The decline of ARM originations to 6.7% in May 2012 from their 2005 peak of nearly 80% indicates a return (if forced) to the fundamentals of responsible borrowing and lending. The last wave of defaults resulting from boomtime ARMs are arriving this year and will soon pass.

No night lasts forever. Agents waiting for the housing recovery will just have to grit their teeth and endure. This time let’s light the candle at one end and try to keep it burning slow and steady.

Related articles:

The iron grip of ARMS on California real estate

Re: “Here Comes the Catch in Home Equity Loans” from The New York Times