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Home equity loans and the business cycle.

Although consumer debt is at an all-time end, it will not necessarily act as restriction on future economic growth; factors such as demographics, convenience use of credit cards, deregulation of the financial services industry, and a new avenue of consumer credit - home equity loans - must be considered. The traditional government statistics on consumer installment credit do not include home equity loans; thus, the home equity portion of consumer debt must be estimated. It is not clear how this small but rapidly growing portion of total consumer debt will reach to changes in the business cycle. Both of these issues are addressed in an effort to estimate the size of this consumer lending segment and to predict its influence.

HOME EQUITY LOANS, the fastest-growing form of consumer credit today, are a new factor affecting the interpretation of all measures of consumer debt. This growth reflects the impact of the Tax Reform Act of 1986, which eliminated the interest cost deduction for consumer installment debt but retained it for some home mortgage loan interest. To measure accurately total consumer indebtedness, home equity loans must now be examined along with other forms of consumer installment debt.

Home equity loans are popular for a number of reasons. First, the rise in home values in the 1970s and 1980s created a huge pool of untapped equity. Second, home equity loans are priced as a lower cost alternative to conventional consumer debt. The impact of tax reform is to alter the after-tax cost of borrowing for consumers with a choice of credit sources, either installment debt or home equity loans. But the change in the cost of borrowing only applies to home equity loans taken out for tax-deductible purposes.

Home equity loans are secured loans using the borrower's home equity as collateral. Unlike second mortgages, home equity loans allow borrowers access to funds at different times in various amounts up to their credit limit. The demand and supply for this line of credit expected to rise for two reasons. First, homeowners will want to take advantage of the tax deduction. The Tax Reform Act of 1986 provides for a five year phase-in for the lost deduction of nonmortgage personal interest payments, which probably will increase the tax deduction advantage of home equity loans during the next five years. Second, the interest rate on home equity loans is lower than straight installment credit because home equity loans represents secured credit. Therefore, homeowners with equity in their homes can get a significant interest rate break by taking out a home equity loan as a substitute for conventional borrowing such as personal, car and education loans.

On the supply side, lenders will be more willing to make home equity backed loans, because the collateral is a more secure asset than that for traditional installment loans. The delinquency rates on home equity loans, like other forms of mortgage credit, is likely to be lower than that for unsecured loans. Because the home serving as collateral backing the loan is also a long-term asset, lenders offer longer maturities, with lower interest rates, than typical consumer credit. The result is a lower monthly loan payment.

Therefore, the debt service burden is reduced, in terms of the monthly payment, by changing the form of debt from installment to home equity loans. In addition, the after-tax interest rate is lower compared to traditional installment loans. This impact reemphasizes the narrowness of the ratio of consumer installment debt to personal income as a measure for the influence of credit conditions on consumer behavior.

Home equity loans are particularly threatening to unsecured forms of credit, such as credit cards. For homeowners, interest rates on home equity loans are below credit-card rates. For lenders, the delinquency rate and fraud losses are higher with credit cards than home equity loans. In time, homeowners are expected to view credit card debt and home equity loans as substitutes. In the short-run, some homeowners are likely to take out home equity loans to pay off large, outstanding credit card balances. This substitution immediately reduces the after-tax interest cost on household debt.


To test the substitution effect, two models were developed. The first model estimated the change in home mortgage debt (FDMORTG) as a function of the change in home values (FDHV) and lagged mortgage rates (RMORTG).

The estimated equation, with t statistics in parenthesis is:

FDMORTG = 57504.9 + 29.2 FDHV - 2441.2 RMORTG

(3.34) (-3.17)

Sample period: March 1978 to June 1986

n = 34 (quarterly data)

[R.sup.2] = 0.80 F (3,30) = 45.96 D.W. = 2.11

Lagrange and LM test fail to reject the null hypothesis of no autocorrelation.

The second model estimated the change of consumer installment debt (FDCIC) as a function of the change in consumer spending (FDC) and consumer credit interest rates (RCIC).

The estimated equation is:

FDCIC = 31.04 + 0.08 FDC - 1.81 RCIC

(2.35) (-2.44)

Sample period: March 1978 to June 1986

n = 34 (quarterly data)

[R.sup.2] = 0.82 F (3,30) = 51.2 D.W. = 2.04

Lagrange and LM tests fail to reject the null hypothesis of no autocorrelation.

If the introduction of home equity loans has the expected substitution effect, actual mortgage debt should rise more than the model forecast, while actual consumer credit should be less than its model forecast. The higher growth rate in mortgages in excess of home values reflects, in part, the influence of home equity loans. Meanwhile, the lower than expected growth in consumer credit reflects a substitution toward home equity loans.

The model results (shown below) confirm these expectations. Beginning in the third quarter of 1986 consumer debt fell sharply below its predicted level. At the same time, mortgage debt rose sharply above its predicted level.

Until the second quarter of 1986, the forecast errors for both equations tended to move in the same direction, reflecting such common factors as consumer confidence and interest rates. But beginning in the second half of 1986 the errors are large and consistently positive compared to earlier periods. This change reflects the substitution effect of home loans on the consumer's choice of credit financing.

The standard errors of the regression are $3.8 billion (Mortgages) and $2.9 billion (Installment Credit). These results again emphasize the offsetting nature of the errors and the large difference between in-sample and out-sample errors.

Estimates of the size of the home equity loan market vary significantly. The latest Federal Reserve release estimates that as of January 6, 1988, home equity loans at commercial banks alone totaled $17 billion. Table 2 below presents three sets of estimates based upon three different methodologies (all estimates are pre-stock market crash).
Size of Home Equity Loan Market
 (End of Period Estimates)
Estimator Year (billions of $)
WEFA 1987 $75
 1988 $135
SMR 1986 $35
 1987 $70
 1988 $100
Our Estimates 1986 $54.4
 1987 $159.6

The WEFA estimates are based upon simulations of a large macro model. The SMR(1) estimates are those of SMR Research, Inc. and reflect forecasts based upon surveys of individual financial institutions. Our estimates are based upon the equation estimates reported in Table 1.
 The Influence of Home Equity Loans
 (billions of dollars)
 Mortgage Installment Home Equity
Period Model Model Loans
 Over Forecast Under Forecast Net Flow Stock
1986:3 $27.7 $ 3.0 $24.7 $24.7
1986:4 22.4 - 7.0 29.7 54.4
1987:1 20.3 - 12.9 33.0 87.4
1987:2 23.3 -8.4 31.7 119.1
1987:3 16.1 -2.6 18.7 137.8
1987:4 19.1 -2.7 21.8 159.6

The future growth of home equity loans is likely to follow the increase in home values because the collateral, the homeowner's equity, is directly reflected in the growth of home values. As expectations of future home values rise, homeowners are more likely to assume a home equity loan. For the lender, an increase in the home's value adds to the owner's borrowing capacity.


The home equity market awakens a number of long-term concerns. First, will borrowers be able to make their loan payments? This question is particularly significant because home equity loan rates are adjustable. As interest rates steadily increase, the payment burden will rise accordingly. Homeowners with both adjustable first mortgages and home equity loans face double jeopardy.

Second, the value of collateral may fluctuate. This issue is particularly relevant given the recent experience in various agriculture and oil-based state economies. In a period of declining property values the loan value of both first and second mortgages may rise relative to the property value. Such a scenario could wipe out all the owner's equity, making default a financial option.

Home equity loans could make the mortgage market riskier. From the supply side the aggressiveness of lenders, as evidenced by "teaser" rates, may lead to overqualifying many borrowers. From the demand side, borrowers may ignore the risk of significant future interest rate increases or economic downturns. In the end, home equity loans could make the home mortgage market more volatile.(2)

This paper has focused on the substitution of home equity loans for consumer installment credit. Alternatively, homeowners may simply add to their total debt burden by using home equity loans to finance further purchases. In the long-term, this may create an overleveraged consumer.


(1) Second Mortgages and Home Equity Loans: Growth, Strategies & Competition. SMR Research Corporation. February, 1987.

(2) In addition, distributional changes occur in consumer credit markets. For a review of these changes, see "Consumer Installment Credit in the 1970s", by William Dunkelberg, et. al., 1980, (unpublished manuscript, Purdue University).

*John Silvia is Vice President and Economist, Kemper Financial Services, Inc., Chicago, IL. Barry Whall is an Economic Analyst, Chrysler Corp. Detroit, MI. This paper is adapted from one presented at the 29th Annual Meeting of The National Association of Business Economist, October 5-7, 1987, New Orleans, LA. Special thanks are due to Van Bussmann, Peggy Ryan, Gerard Francovic and Steve Hotopp for research support.
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Author:Silvia, John E.; Whall, Barry
Publication:Business Economics
Date:Jan 1, 1989
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