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Home Equity Lines of Credit: The Next Looming Disaster?


An in-depth look at these second liens and the dangers they pose for the housing market and large banks.

Editor's note: Keith Jurow is the author of the MVP Housing Market Report.

In a previous article I discussed the madness of borrowing through home equity lines of credit (HELOC) during the bubble years. Now is a good time to take an in-depth look at these second liens and the dangers they pose for the housing market and the large banks.

A Brief Explanation of HELOCs

A HELOC is quite similar to a business line of credit and has some similarities to a consumer credit card as well. Using the residence as security, a homeowner is given a line of credit with a prescribed limit upon which the borrower can draw at any time.

The homeowner receives a draw period of anywhere from five to 10 years when funds can be drawn. During this draw period, the borrower is usually required to pay interest only. The rate is adjusted monthly and is pegged to the prime rate. The repayment period is typically 10 to 20 years. The monthly principal payment is usually the outstanding balance at the end of the draw period divided by the number of months in the repayment period.

Because qualifying standards were based primarily on the equity in the home, HELOCs became nearly irresistible in those states where prices were rising rapidly in 2004-2005. Homeowners discovered that their home had actually become a money tree which they could shake almost at will.

Madness of HELOC Lending During the Bubble Years

Aided by the seemingly limitless desire of banks to lend money, homeowners opened an incredible number of HELOCs during the bubble years of 2004-2006.

Nowhere was the madness of HELOC-borrowing more astounding than in California. During the two key years of 2004 and 2005, a total of 1.43 million HELOCs were originated in California just for the purchase of homes, according to figures received from CoreLogic.

"Wait a minute," you say. "That's more than the total number of homes sold in California during these years." Correct. A total of 1.25 million existing single-family homes were purchased in California in 2004-2005 according to the California Association of Realtors.

At first, these California HELOC numbers may be a little puzzling. However, they make sense when you consider the speculative mania that occurred during the bubble years. In my earlier article about investor speculation, there was an example of caravans filled with out-of-state speculators looking to buy investment properties in Austin. One was a young Californian who had sold a few of his Phoenix investment properties so he could roll his profits into Austin homes.

This is what thousands of HELOCs were used for in California. In 2004-2005, borrowers would take out a purchase HELOC to buy investment properties in other hot markets such as Las Vegas and Phoenix. While the loans were recorded as California HELOCs because the borrower's property was in California, the purchased home was actually in another state. CoreLogic provided the following HELOC origination numbers for California.

According to CoreLogic, an additional 868,000 HELOCs were originated in California during 2004-2005 as "cash-out" refinancings of previous HELOCs. These homeowners tapped their piggy-bank house by refinancing their HELOC with a larger available credit line.
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