The Home-Equity Door Slams Shut

Anxious lenders are freezing lines of credit. Borrowers are in a fix.

By Pat Mertz Esswein, Associate Editor

From Kiplinger's Personal Finance magazine, July 2008

This past January, Lisa and JR Falkenhagen opened a letter from Countrywide Financial informing them that, effective immediately, they could no longer withdraw funds from their home-equity line of credit. The reason: a significant decline in their home's value from the appraised value when the loan was made.

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Lisa, 31, an office manager for a Re/Max real estate agency, and JR, 31, a Web developer, purchased their home in Lynnwood, a suburb of Seattle, in the fall of 2005 for $400,000 with a 20% down payment. A year later, they took out the $80,000 line of credit from Countrywide and immediately tapped $24,000 of it to put a down payment on a ski-resort rental property.

The Falkenhagens used another $40,000 from the home-equity line for home improvements and to help make the $1,650 monthly mortgage payments on the resort cabin, especially during the off-season summer months. Between the two mortgage payments and monthly payments on the home-equity line, the couple already felt pinched.

To gain some breathing room, the Falkenhagens tried to downsize to a smaller house; they received one offer for $460,000, which was $60,000 below their original asking price, and turned it down. Next, they tried unsuccessfully to sell the cabin. As a last resort, they refinanced the mortgage on the cabin and now make an interest-only payment of $1,400 monthly.

Some 122,000 borrowers with Countrywide home-equity lines of credit, or HELOCs, received letters in January. A few months later, thousands of customers of other major lenders -- including Bank of America, Chase, Citibank, SunTrust, USAA, Wachovia, Washington Mutual and Wells Fargo -- also received notice that their lines had been frozen or reduced.

It's a jolt to borrowers who have relied on their home-equity line as an emergency fund or as an all-you-can-eat buffet. Lisa admits that she and JR used the line of credit on a "buy now, pay later basis," but they still feel as if Countrywide pulled the rug out from under them.

Growing cautious. Home-equity lenders' anxiety has soared along with mortgage delinquency and foreclosure rates. That's because when borrowers default, second-lien holders are unlikely to collect a cent after the first-mortgage holder gets its due.

Lenders uniformly cite their right, as disclosed in HELOC contracts, to reduce or suspend a borrower's line of credit if home values fall significantly or if the ability to repay the loan is in jeopardy. Beyond that, they won't say much. Home-equity executives from five banks that we contacted were unavailable for interviews for this story. Their published statements typically invoke the need for sound risk management and responsible lending. "I do understand that it's human nature to ask, 'Why are you withholding my money?'" says Joe Belew, president of the Consumer Bankers Association. "But this is a loan, not an entitlement program."

True enough. But the banks fail to acknowledge their role in helping to create the problem, lending generously even after federal regulators admonished them at the height of the boom to "stress test" their portfolios for the risks of declining home prices and rising interest rates. Like homeowners, lenders counted on rising or gently adjusting prices to soften the risk in their loan portfolios.

Are you next? As home prices continue to fall, lenders will certainly mail more letters. Lenders find themselves "pricked by many unhappy thorns," says Keith Gumbinger, vice-president of HSH Associates, a publisher of mortgage information. Their litany of problems, he says, includes loan losses, regulatory scrutiny, pressure to increase capital reserves and unhappy shareholders.

Declining local home prices may prompt your lender to padlock your home-equity line. But Gumbinger says lenders are also looking for other clues to risk: You were a borrower with poor credit quality to start with; the line of credit was part of piggyback financing to buy your home with little or no down payment and no private mortgage insurance; your credit report reveals financial trouble, such as late payments on a credit card or auto loan; or you took the HELOC through a third party, such as a mortgage broker or finance company, and not the lender that now owns the loan -- an arrangement that has produced a major portion of troubled loans.

What to do. Lenders who pull the plug will invite you to contact them to discuss your situation and appeal the decision. You may have a case for appeal given that the "automated valuation method" that lenders use to determine property values tends to paint with wide, geographic brush strokes. To prove your case, you'll have to pay for a walk-through appraisal of your home, which could cost you $200 to $400. Or you may be able to provide "comps," a record of recent compar-able sales in your area (your lender will tell you how recent and how near).

Countrywide's letter to the Falkenhagens assured them that they could regain access to their credit line by notifying the company in writing, with "satisfactory documentation," that their property value and equity had sufficiently increased. When they were approved for their HELOC in late 2006, their house appraised for $435,000. According to S&P/Case-Shiller, home prices in Seattle have declined since then. The couple chose not to pursue an appraisal, figuring that they'd be wasting their money.

Countrywide's letter also advised borrowers who had outstanding checks to contact the company to discuss how they would be handled. Borrowers who had planned to use their line of credit for a major expense within the month were told Countrywide would try to work with them. Homeowners in the midst of major home-renovation projects were asked for signed statements from their contractors. Washington Mutual spokeswoman Sara Gaugl says that her company, too, "will continue to assist customers who may have unique or special situations."

If you still have access to your line of credit, you may be tempted to max out the line immediately and stash the money in a savings or investment account. Sheryl Garrett, a financial planner in Kansas City, Mo., says that isn't a great idea. She points out that it's too tempting to use the money, which is secured by your home, for nonessential purchases or to pay down credit cards. And if home prices in your area continue to decline, you could find yourself owing more on your home than it's worth.

Some borrowers worry that their credit score will suffer when their line of credit is frozen because the credit-scoring model will assume they "maxed out" their credit. Ethan Dornhelm, of Fair Isaac, which issues FICO scores, says that FICO's scoring model is designed to exclude HELOCs from such calculations.

Harder to get a HELOC. Surveys by HSH Associates show that in some parts of the country, new home loans are now limited to 65% of a home's value. Scott Lugar, head of consumer lending for Internet bank ING Direct, says that in certain communities -- especially in California and Arizona, where home values are "clouded" and difficult to pin down -- the company might choose not to do business at all right now.

Even in places where home prices have remained flat, it's unlikely you can borrow up to 90% or 100% of your home's value, as was common a few years ago. Piggyback loans used to avoid private mortgage insurance have all but disappeared. You'll have to produce full documentation of your means, and you'll need a minimum FICO score of 680 -- possibly more if you're self-employed.

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