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HOME EQUITY LENDING
Home Equity financing is perhaps the fastest growing area within residential mortgage lending. It is a profitable category of business for mortgage lenders, an important product set for loan originators, and a class of loans beneficial to many homeowners in various circumstances. Home Equity loans and lines of credit are prized as sources of loan funds, often considered preferable to automobile loans, credit cards, student loans, store charge accounts, and other forms of unsecured debt. That is because Home Equity products frequently are priced by lenders at lower interest rates than these other forms of debt, and for most borrowers under most circumstances the interest on Home Equity loans and lines of credit is tax deductible. A homeowner can arrange for a Home Equity loan when acquiring the property or afterwards, when he already possesses the property. Home Equity financing usually, but not always, appears as a subordinate lien on a home. That’s why the term “second mortgage” is often used synonymously with the term “home equity loan.” When there is a first mortgage in place, that lien has legal priority over the claim of the Home Equity lender in the event of default or foreclosure. Before the Home Equity lender can recoup its loan funds if there is a foreclosure, the first lender’s debt must be satisfied. Proceeds from the sale of the home first go to repaying that loan balance, plus accrued interest, fees, and costs of collection. There frequently is little or even nothing left to repay the Home Equity lender. That makes Home Equity lending more risky than traditional first mortgage lending, which explains why rates are often higher on Home Equity financing than first mortgage loans.
Product Types Home Equity mortgages fall into one of two types, although in recent years we have seen hybrids of the two. The first general type is the Home Equity Line of Credit (also sometime called a “HELOC”). This is the most popular Home Equity product, especially when short-term interest rates are low. Lines of credit are set up as revolving facilities, similar in nature to credit cards. During the initial, or draw-down period of the loan, the borrower has access to the line or credit. Borrowers may draw down, or borrow, all or a portion of the available line of credit. Each month they are required to pay the accrued interest. Depending upon the lender’s terms and conditions, the borrower may also be required to pay down a portion of the outstanding balance. The borrower may continue to draw down and repay all or a portion of the available line, borrowing and repaying funds over and over again. Once the access, or draw-down period has expired, the borrower is required to repay the balance of the loan over the remaining loan term. The total term of the line of credit may range typically from five to thirty years, with the draw-down period usually lasting five to ten years. The interest rate on most lines of credit is based on a known index such as the Prime Rate (“Prime”). Some lenders use LIBOR (London Interbank Offered Rate), Treasury bill rates, or perhaps other indices, but the vast majority of lines are based upon Prime. A margin over or below the index is then added or subtracted, and that determines the rate. For example, if Prime is at six percent, and the loan note indicates that the rate is Prime plus 1%, the borrower’s rate is therefore 7%. Most lines of credit have variable rates, meaning that as the index moves up or down, the borrower’s rate moves accordingly. That can have an impact on the borrower’s monthly payment, both during the draw-down period and the repayment portion of the loan term. Some lenders establish floors and/or ceilings or caps, below or above which the rate cannot move. The second broad category of Home Equity product is the fixed rate loan. These work in similar fashion to traditional fixed rate first mortgages. The lender funds the entire balance of the loan at the beginning of the loan term, and the borrower repays the debt in fixed monthly installments based upon an amortization schedule. The amortization schedules generally range from five to thirty years, and the loans may be fully amortizing, which means the amortization period and the loan term are identical. Or, the loan term could be shorter than the amortization period, which means that the remaining balance of the loan is due to be fully repaid on or before a specific date. This would create a balloon payment. As previously mentioned, a limited number of lenders are offering hybrid products combining features of both lines of credit and fixed rate loans. One such example allows the borrower to utilize their mortgage as a line of credit for a certain period of time. After the expiration of this first portion of the loan term, the loan balance is then repaid based upon a fixed rate with fixed payments for the remainder of the loan term. Both credit lines and fixed rate loans have their advantages and disadvantages. The loan officer and borrower must evaluate the borrower’s circumstances, needs, and risk tolerance, and then match them up with the Home Equity product that has the most appropriate terms and conditions.
Lines of Credit Advantages
Disadvantages
Loans Advantages
Disadvantages
When and Why are Home Equity Lines and Loans Used? Home Equity mortgages are obtained at one of three times. The first is when the property is being acquired by the homeowner. Second, when the homeowner refinances the first mortgage on the property. The third possibility is some time thereafter, when the borrower already owns the home, has some equity in the property, and wishes to utilize this equity as collateral to obtain funds either for reserve purposes or some other specific use. When placed on the property at time of acquisition or first mortgage refinance and behind a traditional first mortgage, the Home Equity financing is frequently referred to as “piggyback” financing. Let’s take a look at the primary reasons why a homebuyer might want to obtain a HELOC or Home Equity loan at the time the property is bought or being refinanced.
Eliminating the Need for Mortgage Insurance Generally speaking, whenever a homebuyer obtains a home and puts down less than twenty percent of the purchase price of the home, the lender requires that the borrower pay for Private Mortgage Insurance (“PMI” or “MI”). This insurance coverage protects the lender in the event of borrower default, repaying the lender a portion of the loan amount if the lender loses money after gaining possession and then selling the property. The insurance premium typically ranges from approximately ¼% to ¾% of the loan amount per year, usually payable on a monthly basis along with the borrower’s principal and interest payments. Many lenders waive the PMI requirement for borrowers putting down less than twenty percent if the first mortgage is not greater than eighty percent, with all or a portion of the remaining funds needed for purchase coming from a second mortgage. Typical loan structures under this scenario include 80/10/10 and 80/15/5 transactions. The first reflects a first mortgage equal to eighty percent of the purchase price, a second mortgage equal to ten percent of the home’s price, and the borrower putting down ten percent. In the second example, the first mortgage is for eighty percent, the second or Home Equity line or loan covers fifteen percent, and the borrower putting down five percent. There are a number of benefits for the borrower in opting for piggyback structuring versus a high loan-to-value first mortgage with mortgage insurance:
Here is an example showing the benefits of the piggyback structure when a borrower is putting down less than 20%. Assume the following facts:
1. The home being purchased costs $250,000 2. The borrower is putting down 5% 3. An interest rate of 7.5% on the thirty-year fixed rate first mortgage 4. The second mortgage is also a thirty-year fixed rate loan at 8.5% 5. The mortgage insurance premium for a 95% loan is .75% per year, paid monthly Option #1 95% first mortgage with private mortgage insurance P& I on the $237,500 first mortgage is $1,660.63 The mortgage insurance premium is 148.44 The total payment is $1,809.07
Option #2 80% first mortgage and 15% second mortgage P& I on the $200,000 first mortgage is $1,398.43 P& I on the $37,500 second mortgage is 288.34 The total payment is $1,686.77
In this example, the borrower reduces his monthly payment by $122.30 per month, or $1,467.60 per year using the piggyback loan structure. If this borrower elected to apply the $122.30 monthly savings to his second mortgage payment by making additional principal reduction payments, the second mortgage would be fully paid off in just over twelve years. Let’s use the same example, except that now the second mortgage is in the form of a line of credit, with the required payment being interest only. We’ll assume that the interest rate is 6%. Option #2A 80% first mortgage and 15% second mortgage P&I on the $200,000 first mortgage is $1,398.43 Interest on the $37,500 second mortgage is 187.50 The total payment is $1,585.93
The monthly payment savings is now $223.14 or $2,677.68 per year. Another way to look at this is that the payment is 12% lower than it would have been with the mortgage insurance option. The borrower potentially could have purchased a home that was 12% more expensive and still had the same payment. From the homeowner’s perspective, being able to buy “more home” for the same monthly cost is a big benefit. From the loan officer’s perspective, he or she benefits to the extent that they are providing a valuable service to their referral sources who benefit from being able to help their customers purchase the best possible home, one that might be a little more expensive than they would otherwise target. A side benefit, but one not to be overlooked, is that if the customer now purchases that more expensive home, the dollar amount of financing originated by the loan officer is greater, increasing that loan officer’s commission. And here is one more way to look at this transaction from a lender’s perspective. Assume that there are two lenders competing for the same borrower’s business. The first lender can only provide high loan-to-value financing by using mortgage insurance. The second lender offers piggyback financing as an alternative. In order for the first lender to match the overall economics, i.e. monthly payment, loan amortization, and so on, the interest rate on their first mortgage would have to be approximately 6.75%. It is extremely unlikely that the first lender could discount its rate so steeply and still complete the transaction in a profitable manner.
Eliminating the Need for Jumbo Mortgage Financing This use is most applicable for high-end borrowers. It enables them to structure their transactions to receive potentially the lowest cost and most stable financing package available. Conventional first mortgage financing transactions can be categorized as either “conforming” or “jumbo”. In the case of the former, it means that the loan amount is equal to or less than a certain amount that is established each year by the Federal National Mortgage Corporation (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). This loan limit establishes the upper end of the size of a loan that these organizations will purchase. [In 2005, the conforming loan limit for single-family dwellings was $359,650.] Typically speaking, loans that are of a conforming amount are priced somewhat lower than are jumbo loans. The spread in rates between conforming and jumbo fixed rates of similar term typically ranges from ¼% - ¾%. Or, in order to retain the same pricing as conforming loan amount financing, the borrower may be required to obtain financing other than in the form of a traditional fifteen or thirty-year fixed rate loan. And generally speaking, fixed rate financing is considered more desirable than adjustable rate financing. Whenever a borrower is either purchasing a home or refinancing a first mortgage and the amount of financing needed exceeds the conforming loan limit, the lender and borrower can examine structuring the transaction using a piggyback second mortgage. The first mortgage loan amount can be up to the conforming loan limit, and the balance of the necessary financing can be in the form of a second mortgage loan or line of credit. For example, assume that a homebuyer is acquiring a home for $500,000 and wishes to put 20% down. Further, we will assume that the conforming loan limit is $359,650. Without the use of a piggyback second mortgage loan or line, the borrower would obtain a $400,000 jumbo mortgage. As an alternative, the transaction could be structured as a $359,650 first mortgage and a $40,350 second mortgage. This enables the borrower to obtain the lowest possible cost fixed rate loan for a significant majority of the necessary financing, with the balance coming in the form of a fixed rate loan or typically adjustable line of credit.
Here is how the payments work out, using the following rates:
Conforming 30-year fixed rate loan 7.5% Jumbo 30-year fixed rate loan 8.0% Second mortgage fixed rate with thirty-year amortization 8.5%
Alternative #1 Jumbo mortgage $400,000 @ 8% P&I payment is $2,935.06 Alternative #2: Conforming first mortgage and piggyback second$359,650 @ 7.5% P&I payment is $2,514.72 $ 40,350 @ 8.5% P&I payment is $ 312.56 Total of the two payments $2,827.28 The monthly savings using the piggyback structure is $107.78 or $1,293.36 per year.
Replacement of less advantageous forms of debt Home Equity financing is often offered by lenders at rates and terms that are considered advantageous when compared with other forms of consumer debt. Credit cards, store charge cards, automobile financing, and other such debts often carry interest rates that are higher than the rates offered by Home Equity lenders. Further, the interest on home equity loans and lines of credit is for many borrowers in many situations tax deductible. When this is the case, that reduces the effective net cost of the financing even further, widening the cost gap between Home Equity financing and other consumer debt. There will also be times when replacing a mortgage borrower’s consumer debt with Home Equity financing will enable the lender to qualify that borrower for a larger first mortgage. An example might be when the borrower has a $10,000 remaining balance on an automobile loan, with a monthly payment of $600. Replace that auto loan with Home Equity financing as part of the structuring of the financing of a home purchase and the net reduction in the borrower’s payment from the auto financing could be as much as $500. This $500 savings could increase the home buyer’s purchasing power by $50,000 or more. The borrower still needs to be diligent in paying off that $10,000 of financing in a reasonably prompt manner, as the discipline built into the automobile’s larger fixed monthly payment will no longer be in place.
Bridge Financing There are times when homebuyers must close on the purchase of a new home before being able to close on the sale of their current residence. The homebuyers, however, are counting on the equity in their current home to satisfy all or a portion of the equity requirements for the purchase of the next home. Some lenders provide short-term financing to help handle this situation. This is known as Bridge Financing. The lender funds a home equity loan or line of credit on the current home, and then is repaid upon its sale and closing. An alternative to this has the lender providing a first mortgage on the new home in the amount that the borrowers planned as their permanent first mortgage. A second mortgage is then funded as well, either a loan or line. When the first home is sold and the equity funds become available, the borrowers pay off or pay down the Home Equity loan on the newly acquired property. The bridge lender can be at substantial risk, perhaps for a limited reward. To start with, the combined loan-to-value on the property on which the Home Equity loan is being placed is typically going to be very high. At the same time, the borrower is going to have more debt than normal, carrying mortgage payments on both homes until the first residence is sold. The borrower may have a sales contract on the first home, but there is certainly no guarantee that the buyer is going to close on the purchase. And assume that everything works out and that the borrower is able to sell the first home in a fairly prompt manner. The lender only collected interest for a short period of time, perhaps not long enough to justify the time and expense involved in booking the transaction. Lenders can mitigate some of their risk and make the transaction more financially worthwhile through a number of means. First, it is crucial to make sure that the borrower has the financial reserves and earning power to carry the extra home for a sufficient period of time. Credit, carefully investigating the property value, and all of the other normal underwriting considerations must be handled in an appropriate manner. And then on the income side, lenders will often charge the borrower a fee over and above the interest rate for the bridge loan. They may require the borrower to pay the closing costs, and will otherwise structure the transaction appropriately. And finally, a big inducement for the lender to enter into bridge transactions is the opportunity to provide the financing on the new residence being purchased. The lender may make the terms and/or pricing of the bridge loan more advantageous for the borrower if the financing on the new home is handled by the bridge lender.
Home Improvement and Decorating If there is equity available, a Home Equity loan is often the most efficient and lowest cost way to finance improvements such as swimming pool additions, upgrading kitchens and baths, roof replacements, major furniture purchases and so on. The home owner should take note that room additions, major home restructuring, and other such projects are perhaps better financed with residential construction and/or home improvement loans. That is something that must be analyzed by the borrower working with the lender to determine the most suitable mortgage product.
Special Events and Education Expenses Weddings and other celebrations that are usually expensive, as well as college and other education costs are excellent candidates to be paid for with Home Equity financing. It may not be an advantageous time for a homeowner to liquidate investment funds or access other financial resources to pay for these types of expenses. Utilizing the equity on one’s home as a ready source of funds for this type of expenditure is often the most cost effective and convenient means for obtaining the needed money.
As a “Just in Case” Reserve Here, the borrower has no specific or intended use for the loan funds. Typically, a borrower would obtain a HELOC, not drawing down any of the funds and therefore not incurring any interest expense. As many lenders are willing to pay all or a potion of the closing costs, the borrower has very minimal, if any expense exposure if he does not use the line. The borrower can arrange for the availability of funds at a time when he does not need them, and perhaps be able to secure the line of credit under better terms than if the funds were needed on an emergency basis due to a job loss or other financial crisis. This may also be accomplished on a more convenient basis if the line of credit is arranged at the same time as when the borrower is obtaining a first mortgage (either purchase or refinance). The borrower can often submit one application, utilize the same supporting documentation, and attend one combined closing, making the overall process quicker and more convenient.
Home Equity Lending is Important to Lenders and Loan Officers As indicated at the beginning of this chapter, Home Equity lending is truly a win-win for all of the participants in these transactions.
Profitability Home Equity lending can be a very profitable area of business for lenders. Many financial institutions value Home Equity loan and line products as an integral portion of their asset holdings, as they offer the potential for high rates of return and protection from interest rate fluctuations. Fixed rate Home Equity loan products are typically priced well above traditional first mortgage rates, often anywhere from one to five percent higher. Interest rates on lines of credit are typically tied to very short-term indices, such as Prime and LIBOR. Lenders are therefore at low risk of holding low yielding fixed rate mortgages in a higher rate environment. A key component of evaluating the profitability on a portfolio of lines of credit is borrower utilization. Some lenders may charge annual fees or other fees to generate income from these loans, but the primary source of revenue from HELOCS is interest income. And interest income is earned only when borrowers have outstanding balances on their credit lines. Lenders actively involved in Home Equity lending will often have sophisticated campaigns and strategies designed to increase their borrowers’ utilization of their credit lines. Mailers and other promotional materials designed to educate and encourage their borrowers may be sent on a regular basis. Some lenders offer their borrowers credit cards tied to their credit lines, so that when the borrower uses the card, the Home Equity facility is drawn upon. Some lenders require draw-downs on their lines at closing, or certain minimum usage of the HELOC, or otherwise the lender may not pay all or a portion of the closing costs or could impose annual fees. All of these strategies, as well as others, are frequently implemented to insure that the lender’s portfolio of outstanding HELOCS consists of well-utilized credit lines.
Additional Sales Opportunities Home Equity lines and loans are an excellent additional sales opportunity for loan originators, helping them build and maintain a growing database of customers. A given client may be a candidate for a new first mortgage perhaps only once every few years. After all, many people stay in their homes five or ten years, or perhaps even longer. First mortgage refinances can be a strong source of business, but typically so when mortgage rates are low. Home Equity mortgages are a way for an astute loan officer to bridge the time period between first mortgage transactions, obtaining business from borrowers who they might not otherwise be able to assist for a number of years. This also enables the loan officer to more closely remain in contact with his or her past borrowers. By remaining in touch with his or her mortgage customers and with them investigating the potential for this additional financing, the loan officer is providing a valuable service and in the process encouraging further repeat and customer-referred business.
More Successful First Mortgage Origination Efforts Lenders offering a full suite of Home Equity products in conjunction with their first mortgage offerings are able to provide a higher and more complete level of service to their customers. Financial institutions and loan originators who fully utilize Home Equity products as an integral piece of their mortgage sales efforts have a huge advantage over lenders and loan officers not offering Home Equity lending. Mortgage insurance replacement and the ability to structure around jumbo loans, for example, are two ways in which the utilization of Home Equity financing directly improves the economics of a transaction. Add in the more involved financial planning aspects available and a key ingredient for a long-term lender/customer relationship is created. Advantage Financial Funding Corp. - The Commons at Lincoln Center - 124 John Robert Thomas Drive - Exton, PA 19341 Office Phone: (610) 594-8880 Fax: (610) 594-6884 Toll Free Phone: (800) 578-8400 Licensed and Regulated by: Pennsylvania Department of Banking Pennsylvania Department of Insurance Pennsylvania Real Estate Commission 
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