Homeowners often set up a home equity line of credit as a kind of emergency use "insurance policy", expecting only to use it in times of economic distress. Others use their HELOCs as an active part of their day-to-day finances. No matter which camp you call into, you need to know that leaning on your second lien for financial support may not be as safe a bet as you think.
In the HELOC loan agreement you'll sign (or have signed). you'll likely find a series of clauses that allow the lender to curtail access to the credit line, accelerate the repayment terms you agreed to or even terminate the HELOC altogether. This could leave you with no access to your home equity when you most need it.
You don't even have to do anything wrong or miss any payments for such a thing to happen, since forces outside your control can trigger such contract clauses. While the contract language may vary from lender to lender, common reasons for suspending access to your line of credit or reducing the amount available for you to borrow include:
- The value of your home declining significantly below the original appraised value at the time the HELOC was opened
- The lender believes that you will be unable to fulfill your payment obligations under the terms of the HELOC due to a material change in your financial circumstances
- You are in default of a material obligation of the terms you agreed to.
"Material obligations" can cover a wide swath of responsibilities, including a failure to pay required fees and charges, failing to make payments on any other mortgage on the property, failure to maintain the property, letting required insurances lapse or failing to provide updated financial information or documentation if requested. Among other things, the lender can also curtail your borrowing if the maximum APR for the HELOC is reached, something neither you nor the lender has any control over.
Lenders can also reserve the right to terminate your line of credit and demand you repay some or all of any outstanding balance in a lump-sum payment. Termination or acceleration clauses may be invoked by the lender if:
- You engage in fraud or material misrepresentation in connection with the HELOC agreement you signed
- You do not fulfil the repayment terms or the agreement
- Your action or inaction adversely affects the home or value of the home or the lender's rights in regard to the house
Other termination reasons might include transferring the title to the property, adding a new mortgage or lien that is has repayment priority over the HELOC lender's lien on the property, if the sole consumer obligated on the HELOC passes away, if the property is taken through eminent domain or a prior lienholder forecloses on the property.
Of course, some of these factors are beyond your control, most especially what happens with home values. Robust housing markets at times give homeowners what might be considered "free equity"; that is, rising home prices may quickly inflate the value of their home and other homes in the area. At such times, homeowners often look to tap equity, but if conditions should turn more adverse and home values should soften, a lender could reduce or curtail your borrowing capability.
Even if it doesn't cause you to lose your job, a wobbly economy could see folks in your market lose theirs. If this occurs, some homeowners will likely fall behind on payments on their mortgages and may sell properties at reduced prices in order to get out from under their obligations. In turn, this might affect the value of your property, and a lender may take action even on your HELOC if you aren't directly affected and have been making your payments on time.
Property values last sagged broadly during the Great Recession. At that time, rising mortgage delinquencies and weakening home prices caused many mortgage lenders to freeze, cut, or completely close home equity lines of credit (HELOCs), in some cases depriving homeowners of their only financial backstop. Worse, by closing home equity lines of credit, a lender may do damage to a homeowner's credit score, as closing a line of credit can affect a borrowers credit utilization ratio.
Why HELOC Lenders May Cut Back
Even in a solid housing market, a second-lien lender runs the risk of getting none of their money back if the borrower fails to pay. This is because the first mortgage lender (first lien holder) is first in line to get his money back, and a foreclosure sale may not bring enough return to pay off both the first mortgage lender and the holder of the second lien (in this case a HELOC). Freezing or cutting (a.k.a. curtailing) HELOC access is one of the few ways a lender can reduce their risk exposure and make sure the borrower doesn't fall behind in the first place.
These days, the banks are managing their HELOC portfolios like credit card accounts, tracking homeowners' overall credit management. They may flag accounts of customers with late payments or black marks on their credit file, even if their HELOC payment history is perfect. Lenders may cut or close lines of credit if the borrowers' debt-to-income ratio doesn't meet certain criteria (for example, if their income drops), or if they learn that the homeowner's credit is deteriorating.
Related: Why didn't my bank notify me of my reduced HELOC?
HELOC Cuts Hurt Credit Scores
On top of the loss of credit, any damage to homeowners' credit ratings adds insult to injury. FICO score formulas developed years ago don't distinguish well between credit extended under a HELOC and credit extended under a credit card account.
A portion of your FICO score is comprised of a "credit utilization ratio," which makes up 30% of your credit score. It's a measurement of your credit balances compared to the total amount of available credit. If your lender were to close or cut a $25,000 HELOC, that's thousands of dollars less credit available to you, causing your ratio to jump and your score to decline.
The good news is that some HELOC lenders may be using newer versions of FICO models that can exclude HELOCs from credit utilization ratios. You don't have any control over it, but if you don't know which version your lender is using, it's possible that you could end up with a lower credit score through no fault of your own if your lender reduces your credit line.
Getting Your Credit Line Back
If your HELOC has been cut back or terminated and you want your credit line back, call your lender and find out what you need to do to get the line reinstated. It may be that you can preserve access to at least some of your line of credit.
If property value is an issue, you will probably need an appraisal to show that your property has held its value, even if your market or zip code may have experienced some reduction in value. Get an appraiser who is approved by the lender and well acquainted with your neighborhood. You'll probably have to pay a few hundred dollars for the appraisal. Take 80% of the property's appraised value, subtract the amount of the current liens against your home, and whatever is left over should be a reasonable amount for a HELOC.
See what's happening with home values using HSH's Home Value Tracker.
If you've hit some kind of credit trigger which spawned the curtailment, find out what you can do to get the issue cleared up. If it's your debt-to-income ratio, calculate it yourself (take the total of your house, credit card, and other monthly loan payments and divide it by your monthly gross income) to see if your debt is 43% or less than your income. If it is, you have an excellent case to get your HELOC back. You may also be able to request access to sufficient funds to complete a mid-stream activity like a home improvement project or cover tuition until the end of the semester, for example. It never hurts to ask or to open a dialogue with your lender.
If there's another reason, such as a lapse in your homeowner's insurance, or a dispute with another creditor has affected your credit report or score, be prepared to get documentation in place that shows coverage is reinstated or discuss and document the credit dispute for your HELOC lender.
Find a Different HELOC Lender
If your mortgage lender won't consider a reinstatement of your HELOC borrowing capability, consider taking your business elsewhere. Not all lenders participate in the second-lien market, and not all participate in the same way, so you may find credit available from other lenders in your area. Assuming you get a new HELOC, you'll use the new home equity loan to pay off any debt on the old one. Of course, you'll pay fees, but if you are depending on a HELOC to help cover gaps in your income stream or cover your child's college tuition, it's probably worth doing.
A Preemptive Strike?
While we don't advocate this practice, some borrowers may decide to take more drastic measures to make certain they've got money available for their needs. They may choose to empty out some or all of the available equity in their home by "maxing out" their credit line with a single draw by writing a check to themselves, then investing the cash in something safe and liquid. However, such a transaction might see you pay a HELOC interest rate perhaps the prime rate plus 2 percentage points, while you're likely to earn a fraction of that in a money market account. As such, your "carrying cost" will be high, but guaranteed access to your money might be worth it.
HELOCs can be very useful as part of a financial plan, helping to smooth over irregular income streams or fund a range of high-cost items, like home improvement or tuition. As valuable as access to the equity in your home can be, one thing a HELOC is not is a guarantee of access to those funds in all situations. Having a HELOC is not the same as having actual savings available to tide you over a difficult stretch.
Gina Pogol and Keith Gumbinger contributed to this article.
