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Minyan Mailbag: Home Equity Line of Credit Put Play


Why homeowners tap their credit.


One of my co-workers told me he received a letter from Wells Fargo (WFC) this week that his Home equity line of credit has been effectively reduced immediately.

He was upset about this and the fact that reduction was immediate. My co-worker said he would have taken the maximum loan had it not been immediate. I was perplexed.

Do people like to borrow money if their collateral doesn't cover the loan?

Minyan KT

Inquiring minds might be wondering if that's a philosophical question of some sort with no real answer. The answer is it's a very legitimate question with answers that vary by circumstance. Let's consider a few hypothetical possibilities.

Case #1:

Consider someone who has an extremely large equity position in their house. Such a person probably would not be upset in the least.

Case #2:

Consider someone who has a HELOC just because it came with the mortgage loan at no cost. I had one of those at one point. It did not cost anything, and it had no annual fee. Although I have a huge equity position, it was a free option so I took it. Why not? I never used it and never intended to.

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If I was offered $200 to close the HELOC as did National City (NCC) (See National City Pays Customers To Cancel Credit Lines) I would have taken the $200 gladly. Then again, I never would have entered into the arrangement in the first place if it had a $350 exit fee as did NCC.

Case #3:

Now consider the plight of someone worried about the loss of a job or someone with possible large unknown expenses (medical tests coming up), or someone worried about college education expenses or whatever. Suppose that person did not have a lot of equity in the house (between 10,000 to $50,000 depending on the appraiser) and a $50,000 line of credit.

That line of credit, while open, for someone who just might be predisposed to walk away from the house if times got tough enough, is like a free PUT option on the house. However, that PUT option lasts only as long as the line of credit.

Once canceled (or reduced), the PUT option is canceled (or reduced). That is one possible reason why your co-worker was upset. All or part of a "free option" was reduced. Had he known in advance, he could have taken the $50,000 and parked it in a CD.

If you assume his HELOC was at 6.5%: He could have parked that in a CD at 5% or so and his annual cost would be 1.5% or $750.

For someone whose job was in potential jeopardy, or whose spouse's job was in jeopardy, or who faced possible huge medical expenses, $750 just might have been considered "cheap insurance" for unrestricted access to $50,000 in one second's time.

Flight To Cash

The type of mentality described in Case #3 above is not only rampant, it's perfectly logical. Indeed, it's one of the reasons M3 has been soaring.

Inquiring minds may wish to consider MZM, M3 Show Flight to Safety for more on this subject.

Some people (and businesses) are tapping lines of credit, while they still can, and parking the money in CDs or high yield savings deposits. Ironically, some misguided souls point to a soaring M3 as a sign of hyperinflation when in fact it is a flight to the safety of cash!

Now consider things from the point of view of the bank. Those tapping credit lines have exactly the wrong risk profile that the bank wants. Is it any wonder that banks are cutting back and even paying customers to close those lines of credit?

The Home Equity Line of Credit PUT Play will soon be history. Those who absolutely need it better get it while they still can.
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