As an increasing number of mortgage lenders re-enter the second-lien originations market, they can mitigate the inherent risks associated with home equity lines of credit and other products by establishing strong underwriting guidelines and thorough processes to quantify and address potential delinquencies.
The increase in interest rates, decrease in mortgage loan refinancing and steady growth of property values has sparked consumer interest in alternative means to access credit. In response to this growing demand, mortgage lenders are once again offering a variety of second lien mortgage products. By learning from the flaws in products offered in the past, mortgage lenders can offer a new and improved product to address the needs of consumers and significantly reduce the likelihood of default.
An obvious risk inherent to second liens is that they are junior or second to the more senior lien on the property, but that fact in and of itself does not mean that second lien mortgage loans are worthless in a default situation.
Given the complexity of working out second liens and the concern over an increase in delinquencies with respect to home-equity lines of credit originated at the peak of the market, there remains a fair amount of trepidation surrounding this product type.
Recent history has shown that second lien holders have a bargaining chip in short sale scenarios (the sale cannot go forward without their consent) that they use to their advantage. Furthermore, second lien lenders are free to seek money judgments and use other collection methods besides foreclosure. In addition, despite prior supposition, empirical evidence suggests that in many circumstances, borrowers are less likely to default on certain types of second lien loans versus first lien loans.
Studies indicate that piggyback HELOCs (as opposed to closed-end seconds) originated for the purpose of avoiding mortgage insurance, and that do not significantly add to the total debt of the borrower, are far less likely to enter default status and have little effect, if any, on the propensity of a default on the corresponding first lien.
It is also important to keep in mind that HELOCs, unlike closed-end seconds, are exempt from the ability-to-repay rule (and resulting liabilities in connection therewith).
These factors and growing consumer demand make HELOCs an attractive product in this constantly-shifting market.
Recent data from Equifax reveals that between January and June of 2015 lenders extended more than $675,000 worth of HELOCs comprising a total credit limit of $70 billion — up 15% over comparable year levels.
Market participants are rightfully asking what can be done to avoid the impending delinquencies of those products originated between 2005 and 2007.
Lenders and liquidity providers should take a hard look at the features of the products offered and the characteristics of eligible borrowers ensuring stringent underwriting and credit criteria, including:
- Combined loan-to-value ratios of below 80%
- Low debt-to-income ratios (less than 43%)
- High FICO scores (at least above 620)
- Confirmation that borrowers have more than one access to credit and additional collateral other than the mortgaged property
- Verification that borrowers have stable income producing jobs as opposed to those that are self-employed or in commission only professions
- Requiring on-going reporting and collateral value analysis.
As HELOCs reach the end of their draw periods and approach repayment, some borrowers face difficulties in making the increased payments resulting from principal amortization or interest rate reset. Some banks, in an attempt to minimize this risk, have implemented tight repayment terms including requiring interest and principal payments from the onset withdrawing interest-only options. To the extent the HELOCs offered will have a balloon payment feature, some suggest mortgage lenders have in place models for measuring the effect of the end of draw period on the HELOC and the risk of delinquency.
The inherent risks of HELOCs cannot be ignored but they can minimized by ensuring that mortgage lenders have strong underwriting guidelines and established processes to quantify and address risks in delinquencies including workout and modification programs.
Shanell Cramer is a partner in the finance group at Alston & Bird LLP.