This week, Comptroller of the Currency John C. Dugan urged banks to consider tougher underwriting standards on home equity lines of credit (HELOCs). In his speech, he suggested that banks should cut back on many of the competitive HELOC allowances used by underwriters during the housing boom:

“Home equity loans and lines of credit grew dramatically in recent years, more than doubling, to $1.1 trillion, since 2002. In part, that’s because of the rapid appreciation in house prices, the tax deductibility feature of home equity loans, and low interest rates.

“But another contributing factor was perhaps not so obvious: liberalized underwriting standards,” Mr. Dugan said, in a speech to the Financial Services Roundtable’s Housing Policy Council. “These relaxed standards helped more people to qualify for loans, and more people to qualify for significantly larger loans.”

These relaxed standards included limited verification of a borrower’s assets, employment, or income; higher debt to equity ratios; and the use of home equity loans as “piggyback” loans that helped borrowers qualify for first mortgages with low down payments and without mortgage insurance, resulting in ever-higher cumulative loan-to-value ratios.”

If banks heed Dugan’s counsel, borrowers may have an even more difficult time taking out HELOCs than they already do in this post-boom market. Here are a few of the common HELOC practices he criticized:

• The use of home equity lines to finance down payments.
• The appropriate use of collateral valuation tools, such as asset valuation models, which the Comptroller said must be closely managed, periodically validated, and supported with sound business rules.
• Income documentation. Although the overt use of stated income has been largely abandoned, some lenders now ask for income information and authorization to verify it, but do not follow through. “This practice is only marginally better than expressly relying on stated income, since it is questionable whether the borrower’s belief that income will actually be verified will really induce a higher level of honesty in providing information,” Mr. Dugan said. “We need to think carefully about whether anything short of actual verification of income is acceptable from a safety and soundness perspective for most borrowers.”
• The extended interest-only structure that home equity credit lines have in the early years of the loan term. Payment patterns can only be a proxy for a borrower’s capacity to handle a given debt level if he or she is asked to make payments that are meaningful. “Interest-only payments reflect a borrower’s capacity to pay interest on a debt, but not the debt itself,” Mr. Dugan said. “Further, this lack of structured payment discipline encourages borrowers to assume greater levels of debt, often to the limit of their ability to make minimum monthly payments. In contrast, higher payments that reduce principal address both these concerns.”

It’s tough to take out a HELOC in today’s market, but it may become even more of a challenge in the next six months.

See Also:

Tighter Lending Standards for HELOCs 

How to Negotiate the Best HELOC Rates and Terms 

Tags | Heloc, heloc underwriting, lending standards