HELOCs: The Next Lending Crackdown?

HELOC balances appear to be surging at their fastest pace in five years—even faster than mortgages, reports Bloomberg.

That’s got ever-vigilant regulators raising an eyebrow. And it’s got certain lenders we talk to expecting HELOCs to be the next area of mortgage rule tightening.

Under the Microscope

Currently, 2 in 5 secured residential loans in this country (roughly 3 million) are HELOCs. Their average outstanding balance is about $70,000 each.

Regulators are worried about the risks they pose, both to the borrowers themselves and to the economy at large.

Here are some of their concerns:

1. HELOCs have large untapped credit limits
   • Borrowers could run up that credit if times get tough.
   • A meaningful minority could run them up to their limits.
   • That makes “the financial system and economy more vulnerable to a rise in unemployment,” says the BoC.
     • How much more, they fail to mention.
   • Of course, the opposite could be argued as well; that having access to HELOC liquidity makes temporarily unemployed borrowers:
     1. less likely to default
     2. less likely to cut back on consumption, and
     3. less likely to trigger a vicious cycle of panic home sales.
   • Moreover, RBC Capital Markets states that “HELOCs might play a role in helping limit mortgage loan losses.”
2. Over-borrowing
   • The ease of spending with a HELOC makes them too tempting to a minority of undisciplined borrowers.
   • That could lead to a “home equity extraction debt spiral,” says the FCAC, or a pullback by overleveraged borrowers on other consumption.
     • This could, in turn, trigger more unemployment.
   • Paying down a mortgage is also forced savings for most Canadians, and a vital part of many families’ retirement strategies.
     • Overborrowing on a HELOC can therefore delay retirement.
   • That said, FCAC acknowledges that “there is the potential for HELOCs to help some consumers diversify their wealth with leveraged investment strategies or to increase their savings by reducing their reliance on…credit cards.”
3. People don’t pay enough principal
   • The Bank of Canada says “around 40% of HELOC borrowers do not make regular payments that cover both interest and principal.”
   • 1 in 4 make only minimum payments.
   • The “large majority of HELOCs [are] not fully repaid until the consumer sold their home,” found the FCAC.
   • Then again, the average HELOC borrower has 83% equity, finds research from Mortgage Professionals Canada.
4. HELOCs have floating rates
   • FCAC argues that this makes people more vulnerable to rising rates.
   • “Nearly one million consumers could experience payment shock if interest rates were to rise by a full percentage point…,” it says.
   • Payment shock clearly depends on a borrower’s available credit and ability to repay it.
     • Most could use the HELOC itself to make payments in a worst case—albeit that’s neither advised nor a guaranteed fallback (sometimes lenders reduce HELOC credit limits).
5. Banks are over-pushing them
   • The FCAC states: “Banks have made significant investments in marketing and promoting readvanceable mortgages. Sales representatives are expected to introduce and sell the product to their customers.”
     • As a result, banks now market HELOCs to a wider cross-section of consumers.
     • In practice, readvanceable mortgages now serve as the “default option” for consumers purchasing a home with a down payment of at least 20%, says the FCAC.
   • 80% of HELOCs are now held under readvanceable mortgages, as opposed to standalone lines of credit.
   • Banks love one particular aspect of HELOCs: that they’re all “collateral charges.”
     • Collateral charges make switching lenders more expensive, and improve bank retention considerably.

The Real Risk

Despite the above, there’s actually less cause for concern than one might think, at least from a systemic risk standpoint.

Here’s why:

• Big bank HELOCs are now harder to get thanks to OSFI’s new (higher) qualification rates
  • Despite the best HELOC rates being sub-4%, most borrowers have to prove they can afford a much higher payment (based on nearly a 6% interest rate today).
  • Moreover, one has to prove they can afford their entire approved limit, even if they only use a fraction of that limit.
• HELOCs entail stricter underwriting than mortgages
  • e.g., debt ratio limits are usually tighter, credit score requirements are stricter, etc.
• They can’t be government insured
  • Hence, HELOCs entail no direct taxpayer risk.
• They require more lender capital
  • Capital is expensive and banks don’t like to lose capital when loans go bad.
• By rule, revolving HELOCs are capped at 65% loan-to-value at most lenders
  • This rule was instituted by OSFI back in 2012 to ensure HELOC borrowers retained enough equity if home prices plunged.
• OSFI requires banks to stress test their HELOC portfolios regularly
  • Banks must assume severe recessions, home price crashes, and other near-end-of-civilization-as-we-know-it scenarios.
• Most borrowers aren’t reckless debt-a-holics
  • ” …The overwhelming majority of consumers keep their HELOC in good standing,” says FCAC.

The Piggy Bank Analogy

Critics charge that HELOCs are turning homes into “piggy banks.” This is easily one of the most overused clichés by mortgage commentators.

Tapping home equity is portrayed as if it’s necessarily a bad thing. Nevermind that borrowers “own” their equity, having worked to build it up.

Presumably these same critics would also tell prudent refinancers how they should spend their disposable income. It’s big brother-ism at its finest.

The truth is, HELOCs can be abused, no question.

But far more often they serve useful purposes, such as providing penalty-free, short-term home financing (since HELOCs are “open”), acting as low-cost sources of investment funds, as alternatives to low-earning emergency funds, as working capital for self-employed borrowers and as alternatives to expensive reverse mortgages. Restricting qualified borrowers from getting them means more consumers lose these important flexibilities.

What to expect…

When multiple government agencies sound alarm bells on a credit product, it almost always leads to more regulation.

This portends bad tidings for some hoping to use a HELOC in the future. Policy-makers could do anything from requiring stricter HELOC disclosures to tightening lending guidelines, to forcing periodic principal payments, to cutting the maximum revolving loan-to-value to 50%.

Whatever the government does, they could potentially take action this year or next. So if you want a flexible HELOC in that timeframe, you might want to arrange one sooner rather than later.