Nearly 16 million U.S. consumers held approximately $474 billion in balances on home equity lines of credit (HELOCs) as of December 2013, according to a new study by TransUnion. The TransUnion study indicated that approximately $50 billion to $79 billion of those HELOC balances could be at elevated risk of default in the next few years. The study also demonstrated how several metrics could be effective at identifying pockets of risk among those borrowers and anticipating when that risk will arise.
As of the end of 2013, more than 92 percent ($438 billion) of HELOC balances had not reached their "end of draw" (EOD) period. EOD is the point where consumers may no longer borrow funds from the line of credit and must repay the outstanding balance with fully amortized payments, i.e. payments of both interest and principal. When that happens, payments can become materially higher for consumers. A majority of those HELOCs have balances exceeding $100,000.
"Home equity lines of credit were quite popular during the housing boom in the mid-2000's," said Steve Chaouki, head of financial services at TransUnion. "For many people, HELOCs represented a low-interest rate opportunity to borrow against the value of their homes, which were rapidly appreciating at the time. HELOCs generally had lower interest rates than credit cards or other loan types, and that interest was often tax-deductible."
TransUnion's research found that nearly half of all HELOC balances at the end of 2013 were originated between 2005 and 2007. Many of these HELOCs had 10-year draw periods, and for those borrowers the draw period will be coming to an end over the next few years.
"The financial shock associated with a HELOC payment increasing to cover both -- principal and interest -- can cause liquidity issues for some borrowers; this dynamic is driving significant concern in the lending marketplace," said Chaouki. "Our study indicates that up to $79 billion of those HELOC balances could be at elevated risk of default in the next few years. Though significant in dollar terms, the study isolated the risk to fewer than 20 percent of balances."
TransUnion's study demonstrated that traditional credit risk scores are quite effective at identifying consumers more likely to default on their HELOCs after EOD is reached. In addition, the TransUnion study yielded several metrics effective at estimating the ability of consumers to absorb a payment shock.
"Credit scores are immensely powerful at differentiating risk in HELOC portfolios, and remain a core component of sound credit risk strategy," said Ezra Becker, co-author of the study and vice president of research and consulting for TransUnion. "In addition, we found that an understanding of consumer cash flows is at the heart of determining if someone can manage a larger HELOC payment each month, and how much larger that payment can grow before the consumer runs into liquidity constraints."
The study also examined the impact of a viable exit strategy on HELOC risk by comparing total home loan balances to housing values provided by CoreLogic. According to the study, consumers with sufficient equity in their homes could avoid HELOC default because they had greater options to refinance the line of credit, or sell the home to become whole on the debt.
Importantly, the study showed the value of understanding the interaction effects between these characteristics. For example, a consumer might have a high credit score but lack the ability to absorb a payment shock. That consumer may demonstrate a higher risk of HELOC default after EOD than a consumer with an equivalent high credit score but with ample cash flow to absorb a payment shock.
"The insights gained by evaluating consumers across multiple dimensions provide a powerful basis for effective risk management strategies," said Becker. "We developed segmentation schemes that differentiated HELOC EOD risk from a mere 0.1 percent default rate to a remarkable 25.3 percent default rate."
The TransUnion study is important not just for HELOC portfolio managers but also for other consumer product lenders, such as credit card, mortgage and auto lenders. "The vast majority of the nearly 16 million consumers with a HELOC carry other forms of debt as well. Our study allows lenders across portfolios to better identify, anticipate and measure how an upcoming payment shock for a HELOC borrower might impact that borrower's ability to repay not just the HELOC but also his credit card, auto loan and other debt obligations," said Becker. "In other words, we've provided a framework for effectively managing that risk."
TransUnion's proprietary research utilized several metrics based on the existing CreditVision® credit report to develop its conclusions on the HELOC market. These included:
►Payment shock estimators for borrowers
►Estimation models for the timing of end-of-draw
►Metrics for evaluating the capacity of borrowers to absorb payment shock
►HELOC and total equity-based balances
"Our approach is easily delivered and incorporated into lenders' strategies. We believe the fact that our metrics are FCRA-compliant and hence actionable will generate a great deal of interest among lenders" added Chaouki. "For HELOC customers, we hope this serves as a reminder that higher payments may soon be on the horizon. Consumers should ensure they are aware of their financial circumstances and, if they are in this type of a situation, prepare for those larger payment responsibilities."