June 18, 2015

“Ten years ago we purchased a house for $310,000 which we financed with a first mortgage for $255,000 at 3.75%, and a HELOC for $65,000 at 3.5%. The HELOC amount was at the maximum right from the start, which has ruined our credit, and very soon our payment is going to increase…how do we get out of this?”

Your loans were made at the height of the housing bubble, and looked like a great deal at the time. By using a HELOC as a “piggyback” second mortgage, you were not required to make a down payment or to purchase mortgage insurance. Furthermore, the required monthly payment on the HELOC was interest-only for 10 years, which reduced the payment – for 10 years. To a greater or lesser degree, your plight is shared today by several million other borrowers who took HELOCs before house prices collapsed beginning in 2006. 

One drawback of your deal occurred immediately – your credit score dropped. The credit scoring systems treat HELOC credit lines in the same way they treat credit cards, penalizing those with high ratios of credit utilization to the maximum credit allowed. While the size of the credit score penalty depends on other features of your credit record, you were not aware that there would be any penalty at all when you took the HELOC. The best way to get this monkey off your back is to pay off the HELOC in a refinance that consolidates the two mortgages.

A second drawback of your original deal, which heightens the need to pay off the HELOC, is that the payment on the HELOC is subject to a double whammy. Very soon the payment will shift from interest-only to fully amortizing – you have to begin paying down the balance. On top of that, you are exposed to a sharp rise in interest rates on the HELOC, which has been a long time in coming but which is likely to begin before the year is over.

HELOCs are adjustable rate mortgages (ARMs) tied to the prime rate, but they are much riskier than standard ARMs. Because rates adjust daily, changes in the market impact a HELOC very quickly. If the prime rate changes on April 30, the HELOC rate will change effective May 1. Don’t be duped by the stability of the prime rate in recent years – it last changed on December 16, 2008. In 1980, it changed 38 times and ranged between 11.25% and 20%. Unlike standard ARMs HELOCs have no adjustment caps, and the maximum rate is a much higher, 18% in most states.

The third and most insidious drawback of your deal was 10 years in the making – you don’t have much equity in your house. You began with none at all when you purchased the house without a down payment, and you have made no principal payments on the HELOC. This means that the only equity you have now is based on the principal payments you made on the first mortgage plus whatever appreciation has occurred in the market value of your home. But given that you purchased your home when prices were near their peak shortly before they collapsed, that may not be much.  

Your objective ought to be to consolidate the two loans by refinancing into one fixed-rate loan. With limited equity, it may have to be an FHA on which the equity requirement is only 3%. You will have to meet expense-to-income guidelines where the expenses will include mortgage insurance and larger mortgage payments. If you meet the requirements, you will be out from under the threat of a drastic increase in the interest rate and payment on your HELOC.   

Many other home-owners who took out HELOCs about the same time as you face a more difficult challenge than you. If they took the HELOC in a separate transaction after their home purchase, rather than as part of the purchase transaction, any subsequent refinance is classified as “cash-out”, subject to a higher interest rate and to a 15% equity requirement rather than 3%. That can be a crusher. The HARP program does not help such borrowers because second mortgage lenders participate in HARP deals only when there is enough equity in the property to protect them, which is seldom the case.   

Borrowers who are unable to meet higher monthly payments on their HELOCs  and don’t have the equity needed to refinance don’t have to default. A better option is to file a Chapter 13 bankruptcy. In a Chapter 13, a court will formulate a payment plan, consistent with the borrower’s capacity to pay, that covers each creditor over a specified period. When borrowers “graduate” from a Chapter 13, they are immediately eligible for an FHA loan.  

Thanks to Jack Pritchard.