Home equity lending.
Personal borrowing secured by equity in residential property has become an increasingly important component of household liabilities. Growing equity in homes, aggressive promotions by financial institutions, and a revised tax code, which retains the deduction for interest on real-estate-secured debt but not on other consumer borrowing, all appear to have contributed to the increasing use of home equity loans. Such credit typically takes either of two forms.1 The first of these, referred to here as a "traditional home equity loan," is a closed-end loan extended for a specified period of time and generally requiring repayment of interest and principal in equal monthly installments.2 The second form is the newer "home equity line of credit," a revolving account secured by residential equity. These accounts permit borrowing from time to time at the account holder's discretion up to the amount of the credit line, and they typically have more flexible repayment schedules than those for the traditional home equity loans.
Until recently, relatively little statistical information has been available on home equity lending. Some information about uses and users of home equity lines of credit became available in 1988 with publication of consumer surveys sponsored in 1987 by the Federal Reserve Board and industry-sponsored surveys of financial institutions (see FEDERAL RESERVE BULLETIN, June 1988, pages 361-73). In addition, the Report of Condition for year-end 1987 made available for the first time comprehensive information about amounts outstanding under home equity lines of credit at commercial banks. None of these sources revealed much about traditional home equity loans, however. To learn more about traditional home equity loans and to relate trends in these closed-end loans to
available information about home equity lines of credit, the Federal Reserve Board again participated in sponsoring consumer surveys in 1988 (appendix A). This article uses the new survey results to provide a more complete report on the market for consumer credit secured by home equity. 1. Another way homeowners may access equity in their home is to refinance an existing mortgage. When the amount borrowed in a refinancing exceeds the amount of the debt represented by the original mortgage plus closing costs, then in effect equity-secured credit has been extended. Such "excess" funds may be used in the same manner as any other home equity type of loan. Refinancings are not discussed in this article. 2. Traditional home equity loans are sometimes called second mortgages, although legally they may involve a first lien.
HOLDINGS OF HOME EQUITY LOANS
The Federal Reserve Board has for many years sponsored surveys of consumers to gather information about their overall financial situation and about their use of specific financial services. These surveys can be used to assess the use of home equity loans over time. Before the mid-1980s, nearly all home equity loans were of the traditional type. More recent surveys provide information on consumer use of both types of home equity credit.
Consumer surveys indicate that 5.4 percent of homeowners had a home equity loan in 1977.(3) By 1983, this proportion had risen only slightly, to 6.8 percent.4 However, surveys taken last year reveal substantial growth in the use of home equity loans since 1983.(5) These most recent surveys found that 11 percent of homeowners, or roughly 6.5 million families, had a home equity loan in the second half of 1988. Closer examination of the 1988 surveys shows that 5.6 percent of homeowners had a home equity line of credit, while a nearly equal proportion, 5.3 percent, had a traditional home equity loan.
Widespread consumer interest in home equity credit line plans dates to 1986, when extensive promotion of such plans by financial institutions began. In that year, the Tax Reform Act mandated the gradual removal of federal income tax deductions for interest paid on nonmortgage consumer credit, enhancing the attractiveness to consumers of using mortgage instruments to fund expenditures that typically have been financed by consumer loans. Favorable interest rates compared with those on many types of consumer credit, particularly credit cards, also have encouraged borrowing against home equity. These features of reduced interest expense and tax deductibility characterize both types of home equity loans. In addition, the convenience of being able to draw as needed against a line of credit has proved to be a particularly attractive feature of the credit line account.
According to the 1988 Surveys of Consumer Attitudes, 31 percent of the families with a home equity line of credit obtained it in 1988, and 83 percent of families with accounts had opened them since 1986. In comparison, about one-fifth of the traditional home equity loans were established in 1988, and 64 percent had been granted since 1986. Looking at 1988 originations alone, 63 percent were credit lines and 37 percent were closed-end loans. Thus, in recent years home-equity-secured credit lines have been the more popular vehicle, but consumer demand for the traditional loan has by no means evaporated.
Moreover, whether the growth of credit line accounts will continue to outpace that of traditional home equity loans is open to question. Two basic factors seem likely to influence near-term developments. First, many creditors have aggressively promoted their credit lines plans with discounted finance rates and waivers or rebates of closing costs and fees. If creditors reduce these promotions, home equity lines of credit will become relatively less attractive. Second, the recent flattening of the yield curve, so that short-term interest rates and longer-term rates are more nearly equal, means credit lines may no longer have a near-term price advantage over the closed-end loans. Typically, rates on traditional home equity loans are more in line with longer-term rates, while credit lines are indexed to shorter-term rates. Until recently, short-term interest rates were well below rates on longer-term instruments, as shown in the chart. As a result, credit line accounts have been priced favorably relative to fixed-rate, closed-end home equity loans for most of the past three years. If the flatter yield curve persists, the difference between the growth rates for the two home equity products should shrink. 3. Thomas A. Durkin and Gregory E. Elliehausen, 1977 Consumer Credit Survey (Board of Governors of the Federal Reserve System, 1978). 4. "1983 Survey of Consumer Finances," (Board of Governors of the Federal Reserve System, Division of Research and Statistics). 5. "Survey of Consumer Attitudes," July-December 1988 (University of Michigan, Institute for Social Research, Survey Research Center).
SOURCES OF HOME EQUITY LOANS
Before the mid-1970s, home equity loans were in large part the province of consumer finance companies, second mortgage companies, and individuals. Today the home equity loan market is dominated by depository institutions, especially commercial banks and to a lesser extent savings institutions (savings and loan associations and savings banks) (table 1). However, some relative specialization by type of home equity loan product is observable among creditors. In particular, finance companies have provided nearly a third of the traditional home equity loans while playing an insignificant role in the market for home equity lines of credit. Among depository institutions, commercial banks and savings institutions have roughly equal shares of the market for traditional home equity loans, but banks are the predominant source of credit lines, accounting for 54 percent of the total market.
The specialization of finance companies in the traditional home equity loan market may in part reflect long-time customer relationships as well as limits on the services available from finance companies. Because finance companies typically do not offer deposit services (except, in some cases, through banking affiliates), they are less well suited to offering credit accounts that can be accessed by check, a feature of virtually all home equity lines of credit. Also, finance companies tend to serve a somewhat lower-income home-owner clientele with smaller amounts of home equity.6 Lenders often prefer to exercise tighter control over the credit use of such customers by granting them loans of specified amounts with predetermined payment schedules. 6. For example, the median incomes of traditional home equity loan borrowers at commercial banks and savings institutions were $55,000 and $40,000 respectively in 1988. In contrast, the median family income of persons borrowing from finance companies was $32,000. See memorandum, "Home Equity Loan Holding and Use: Results of 1988 Consumer Surveys," to the Consumer Advisory Council, January 24, 1989, table 4.
USERS AND USES
OF HOME EQUITY CREDIT
In general, home equity credit users fit the profile of a financially sophisticated, "upscale" group of consumers. However, important differences exist between holders of credit lines and users of traditional home equity loans. Moreover, differences among customers of each product in demographic characteristics, in uses of the funds, and in the perceived attractiveness of the two credit products all suggest that they may not be close substitutes in the minds of many consumers.
Demographic Characteristics of Holders
of Home Equity Loans
Families that have a home equity credit line typically have higher incomes and have built up substantially more equity in their homes than homeowners in general have, or those with a first mortgage only (table 2). Families with traditional home equity loans likewise have higher incomes and more equity than the average first mortgagee, but they have significantly smaller amounts of each than holders of credit line accounts have. In 1987, families with credit line accounts had median incomes of $51,000, and holders of traditional home equity loans had median incomes of $43,000. In comparison, the median income for those with a first mortgage only was $38,000. Median amounts of home equity were $83,000 for credit line holders, $43,000 for those with traditional home equity loans, and $35,000 for those who had a first mortgage only. Those borrowing against home equity also tend to be older than homeowners with a first mortgage only; in part their higher incomes and home equity may reflect the fact that older homeowners have probably progressed further in their careers and have owned their homes longer. Homeowners with no mortgage debt at all tend to have sizable equity and relatively low incomes; the median age for this group is 65, and many of them are on retirement incomes and have owned their homes for a long time.
The strong correlation between the use of home equity for loan collateral and levels of family income and equity is further illustrated in table 3, which groups homeowners by income and equity categories and shows the proportion of each group that has one or the other type of home equity product. The data reveal that home equity lines of credit in particular are an upscale product, with larger proportions of each of the higher-income groups ($35,000 or more in annual income) holding a credit line account rather than a traditional home equity loan. The other demographic characteristics in tables 2 and 3 do not show significant differences between holders of credit lines and users of traditional home equity loans, although the latter are somewhat more likely to be nonwhite or Hispanic and to have had somewhat fewer years of formal schooling than credit line holders.
The geographic breakdown in table 3 illustrates the pronounced regional character of the market for home equity lines of credit. Twelve percent of homeowners in the Northeast have a credit line account, compared with an average of 4 percent for the other three major regions. A similar, though less pronounced, geographic pattern also characterizes the market for traditional home equity loans. The Northeast is, of course, a part of the country where incomes and real estate values have both grown rapidly, and it is also the home of many financial institutions that have aggressively promoted home equity loan products.
Amount of Borrowing
Users of credit line accounts and traditional home equity loans also differ considerably in the amounts they have borrowed (table 4). Survey data for 1988 reveal that, on average, credit line users (disregarding those with no outstanding balances) owe considerably less than users of traditional home equity loans. For example, 9 percent of credit line holders owe $25,000 or more compared with 25 percent of those using closed-end home equity loans. The mean and median amounts owed by traditional home equity loan users in 1988 were $19,000 and $15,000 respectively, compared with $13,000 and $10,000 respectively for credit line users.
Thus far, consumer use of home equity lines of credit has been moderate; in particular, the amounts that consumers owe are typically well below the maximum amounts allowed under their plans. The median credit line available to survey respondents was $31,250, more than three times the median amount actually owed. In addition, the surveys reveal that many credit line holders (about 41 percent) have no balance outstanding (table 4). Of these, nearly 85 percent have never used their account, while the other 15 percent have paid off a previous obligation and currently carry no balance. Some of those who have never activated their credit line accounts are new account holders (they have had the account less than six months), but the majority are not. Most holders of these accounts appear to have established them as standby lines of credit.
Since many creditors offering home equity lines have either waived or rebated closing costs as a marketing device and since most creditors do not assess any fees to maintain an account, it is not surprising to find that some consumers have arranged for these lines of credit but have never drawn on them. Nevertheless, the high proportion of credit line holders who either have never drawn on their accounts or have repaid outstanding balances in full is surprising and appears inconsistent with information provided by creditors. Some industry estimates suggest that in 1987 the proportion of home equity credit lines without an outstanding balance was in the range of 15 to 20 percent.7 7. "Home Equity Credit Report" (American Bankers Association, no date), table 16, p. 36.
Purposes of Borrowing
Historically, surveys have found that consumers have used traditional home equity loans primarily to repay other debts and to finance home improvements.8 The 1988 surveys show that these uses are the most prevalent ones for both types of home equity loans, although there are some differences. Outlays for education, medical expenses, and vacations are relatively more important uses of credit line borrowings than of closed-end debt. In contrast, financing purchases of real estate has been a somewhat more common use of closed-end loans. These differences in use apparently stem from the differing features of the two products. The convenient availability of multiple draws on the credit lines suggests that they will be more attractive to consumers for relatively small purchases, such as home appliances, for unanticipated outlays, such as some medical expenses, or for outlays recurring over time, such as college tuition payments. On the other hand, real estate transactions often are large, one-time events that may be relatively better financed with a traditional home equity loan. 8. 1977 Consumer Credit Survey, p. 92.
ADVANTAGES AND DISADVANTAGES OF
HOME EQUITY PRODUCTS
Further differences emerge between users of credit lines and users of closed-end loans regarding their views of the advantages and disadvantages of their chosen loan type compared with other consumer credit products. For example, nearly 50 percent of credit line holders cited the convenience of obtaining money as needed as an important advantage; only 7 percent of traditional home equity loan users mentioned this factor (table 6). In addition, in comparing users of the two types of loans, a larger proportion of the credit line holders mentioned cost, principally a lack of fees, as an important advantage. Many observers have suggested that tax deductibility of interest payments likely is an important factor contributing to the recent growth of home equity credit lines, and the survey responses support this conclusion. Nearly 30 percent of credit line holders and 16 percent of traditional home equity loan users mentioned tax deductibility as an advantage of home equity loans compared with other types of consumer credit. Consumers also cited several potential disadvantages of home equity products. Roughly equal proportions of the users of each type of home equity product mentioned the risk of losing the home as a disadvantage, but credit line holders expressed concerns about possible debt overextension twice as frequently as users of traditional home equity loans. Likewise, a higher proportion of credit line users cited cost (interest rate) as a disadvantage of this type of credit, probably reflecting simultaneously the sensitivity to prices of this upscale group of borrowers and the variable rates on most of these accounts.9
In sum, survey evidence suggests that holders of credit lines and users of closed-end loans represent different market segments, albeit with some similarities and overlaps. Credit line holders have somewhat higher incomes and more equity in their homes, but, so far at least, have borrowed less. Debt repayment and home improvement are the main uses of both kinds of loan, but the credit lines are also used more broadly for other purposes. Credit line holders are more likely to mention convenience as an advantage, but they also more often mention the cost in terms of variable interest rates and the risk of possible debt overextension as disadvantages.
Significantly, lack of knowledge about alternatives does not appear to be associated with the selection of loan type. The 1988 surveys show 9. Virtually all credit line accounts have a variable interest rate feature, typically one that allows monthly adjustments that are indexed to changes in the prime rate or to some other short-term money market rate.
Table : 1. Sources of home equity loans
Table : 2. Characteristics of homeowners, by debt status
Table : 3. Proportion of homeowners with home equity loans, by demographic characteristic
Table : 4. Outstanding balance on home equity loans
Table : 5. Purpose of home equity borrowing, by type of loan
Table : 6. Advantages and disadvantages cited by holders of home equity loans, by loan type that 92 percent of all homeowners are aware of that availability of traditional home equity loans, and 75 percent are aware of home equity lines of credit. In comparing the two types of credit, about 90 percent of users of each type were aware of the availability of the other product. But, despite their high levels of awareness, most users of either a traditional home equity loan or of a credit line account did not seriously consider the other type of credit instrument before obtaining their current loan. Among homeowners with a traditional home equity loan, only 16 percent considered obtaining a line of credit instead. Similarly, among homeowners with a credit line, only 20 percent considered taking out a traditional home equity loan. This lack of cross-product shopping likely reflects factors such as the differences in loan purpose discussed earlier. For instance, as previously noted, many credit line holders seem to have established their accounts as standby lines with no immediate use intended, and roughly three-quarters of them mentioned convenience (in one form or another) as a key advantage of that loan product.
EFFECTS OF HOME EQUITY DEBT ON THE
ECONOMIC BEHAVIOR OF HOUSEHOLDS
The growing importance of home equity debt in household balance sheets may have implications for the economic behavior of households. The June 1988 BULLETIN article, for instance, explored the question of how the availability of home equity credit lines might be affecting aggregate consumption and borrowing. That article concluded that home equity lines were primarily substituting for other types of debt and therefore had not expanded the total volume of household borrowing; likewise, it concluded that any effect on aggregate consumption was probably quite small. Another behavioral issue is whether the variable-rate structure of most home equity lines and some traditional home equity loans might affect the economic behavior of households in some way, particularly during periods when the general level of interest rates is rising. This question is addressed in the following sections.
Aggregate Home Equity Debt
Before examining the sensitivity of households to movements in interest rates, it might be useful to gauge the aggregate amount of home equity debt outstanding. Comprehensive statistics are not available, but rough estimates can be constructed from reports for some lender groups together with inferences from the household surveys. Debt outstanding under home equity credit lines can be estimated at about $75 billion at the end of 1988; a less precise estimate puts the amount of traditional home equity loans somewhere between $135 billion and $190 billion. The total market for home equity debt thus ranges from about $210 billion to $265 billion, or between 10 and 12 percent of all home mortgage debt on 1-to 4-family residential properties.
Commercial banks (since December 1987) and FSLIC-insured savings institutions (since June 1988) have been itemizing their receivables under credit lines on the Reports of Condition that they file quarterly with their respective supervisory agencies. These reports, which cover the two largest institutional segments of the market for home equity lines, provide a solid foundation for estimates of revolving home equity debt; a sample of commercial banks also supplies such data to the Federal Reserve on a weekly basis. However, because debt incurred through traditional home equity loans is not reported separately, it remains embedded in the total of home mortgage debt outstanding, with no means available to separate it out.
Responses to the consumer surveys indicated that commercial banks and savings institutions (including mutual savings banks) may have accounted for 85 percent of the credit line accounts in place during the second half of 1988. Compilations from the Reports of Condition establish that at the end of 1988, commercial banks had receivables under credit lines of $40 billion and FSLIC-insured savings institutions had $11 billion. In the absence of data for mutual savings banks (MBSs), an estimate of $10 billion is used here.(10) Adding the figures together gives an estimated total of $61 billion in revolving home equity credit outstanding at these various depository institutions. If this total for depositories is inflated to account for the 15 percent of credit line accounts held by other lenders, then the year-end aggregate for all lenders approached $75 billion.(11)
In the absence of any direct means to isolate the amounts of traditional home equity credit on lenders' books, deriving an aggregate estimate for that type of lending is more problematic. Some inferences can be drawn from the survey data, however. For instance, the survey indicates that the mean balance outstanding on a traditional closed-end loan is about one and one-half times the average balance on an active home equity line of credit. Further, after subtracting out credit line accounts with no balances-about 40 percent of all accounts, according to the survey--the ratio of traditional loans to active credit line accounts is about 1.6 to 1. Multiplying together these ratios of size of balance and number of loans (accounts) suggests that outstanding debt on closed-end loans may be about two and one-half times the amount of debt under credit lines. If the estimate offered here of about $75 billion in revolving credit is accurate, then traditional home equity debt may have been as much as $190 billion at year-end.
If, however, inaccuracies exist in the mean amounts of debt outstanding or in the proportion of credit line accounts with no balance that was calculated from the survey, then the above estimate of traditional home equity credit could be off target. For example, if industry estimates of 15 to 20 percent for inactive credit line accounts are closer to the mark, then we would have to pare the estimate of traditional home equity loans outstanding (other things equal) to about $135 billion.
Effects of Variable Rates
With the development of adjustable-rate mortgages early in the present decade, the interest obligation on the existing stock of household debt began to become more responsive to general movements in interest rates. This trend has continued with the advent of home equity lines of credit, virtually all of which have variable rates, insofar as these credit lines have substituted for consumer debt and for traditional home equity loans that have been largely fixed in rate. In recent years, even some of these types of debt have been made with adjustable rates, but not nearly to the extent that home equity lines have been.(12)
The prime rate has served as, by far, the most common index to which the variable rates on home equity lines have been pegged. About three-quarters of all providers of these credit lines use the prime rate for this purpose. Rates on Treasury bills, typically of 90-day or 6-month maturity, have been used by virtually all other institutions. Two-thirds of the providers adjust rates monthly, and most of the rest adjust quarterly. Moreover, few lenders at present provide any annual limit on rate increases. The use of market-sensitive indexes with frequent adjustments and little constraint on rate levels means that the average interest rate applied to the stock of credit line debt should move closely with money market rates.
How rate adjustments affect the payment obligation of the typical credit line holder can be estimated with the help of the survey statistics. As noted earlier, the mean outstanding balance on an equity-secured line of credit is about $13,000. For each percentage point of interest, a borrower would pay $10.83 a month. A common markup over prime is 1 1/2 percentage points. With the prime rate at 8 1/2 percentage last spring, the typical borrower with a $13,000 balance and an interest rate of 10 percent would have paid $108 of interest each month. By December, when the prime rate had risen to 10 1/2 percent and the rate on credit lines thus to 12 percent, this borrower would have paid $130 in interest, assuming approximately the same balance outstanding. (10). While MSBs have substantially fewer mortgage assets than commercial banks, their business is concentrated in the Northeast, which, as noted, has been a region of particularly heavy use of home equity accounts. Several MSBs are known to have large portfolios of home equity credit lines. (11). Based on a similar methodology, but using less complete data on receivables and a less reliable estimate of market shares, an estimate of $75 billion outstanding at the end of 1987 was presented in the June 1988 BULLETIN article. It now appears that the year-end 1987 figure was closer to $60 billion. (12). In the 1988 survey of households, 16 percent of the traditional home equity loans held by respondents had an adjustable rate of interest.
Whether changes in interest obligations of this magnitude might stimulate some curtailment of current spending or a reduction of debt by consumers is difficult to say. At the margin, these changes presumably would have some effect, but its significance is open to question. One practical consideration is that a rise in the interest rate on a credit line balance need not increase the monthly payment. Only those borrowers faced with an "interest only" minimum payment requirement and who customarily pay the minimum would necessarily be obligated to make a higher payment. More commonly, lenders set minimum payments at some percentage of the outstanding balance (for instance, 1 1/2 percent). A minimum payment of 1 1/2 percent on the mean balance of $13,000 would be $195, more than enough to cover the interest payments calculated above. In these circumstances, of course, the loan balance would amortize more slowly. Borrowers who found this development undesirable might then adjust their behavior in some fashion.
Another consideration is that holders of credit line accounts have higher incomes than other homeowners or other households in general, as shown in table 2. They also have substantially more home equity than the average homeowner. The surveys did not obtain data on any assets of households other than home equity, but it seems clear that holders of home equity credit lines tend to be financially well situated. Therefore, higher interest payments would be unlikely to impose a serious constraint on their spending.
A broader examination of household sector behavior reveals that the cash flow of some households improves with rising interest rates because they hold variable-rate (or short-maturity) financial assets. In the aggregate, interest-paying assets of households exceed their interest-bearing liabilities by roughly 50 percent, and in 1987 households received interest of nearly $315 billion and paid out interest of about $255 billion, according to the latest available data. Many assets, like many liabilities, carry fixed rates, of course, and therefore the overall effect of rising interest rates on receipts and payments of consumers is hard to quantify. It appears likely, however, that the net cash flow to the sector as a whole would increase with a rise in interest rates.
If increased interest receipts outweigh higher interest payments when rates rise, consumer spending might increase. However, a rise in interest rates causes the current stock of wealth to be revalued downward, which is apt to exert some pressure on spending. Moreover, taking account of even broader economic effects, higher interest rates, by raising financing costs, tend to restrain aggregate economic activity and thus to reduce labor income. This chain of economic consequences also points toward lower consumer spending.
In sum, variable-rate debt makes the cash flow of consumer-debtors more vulnerable to constraint in times of rising interest rates, but, for the sector as a whole, increased interest receipts probably outweigh the higher interest payments. In any event, the positive effect on cash flow is just one way in which higher interest rates affect consumers. The negative effects of higher interest rates on consumer wealth and on aggregate demand operate to reduce consumer spending.
DEVELOPMENTS IN PUBLIC POLICY
In recent months, legislative and regulatory actions have been taken that will influence the future development of the home equity loan market. Two statutes, the Competitive Equality Banking Act of 1987 (CEBA) and the Home Equity Loan Consumer Protection Act of 1988 (HELCPA), added new Truth-in-Lending requirements regarding credit linked to home equity.(13) Also, in late 1988, the Federal Reserve adopted new capital adequacy guidelines.(14) The guidelines establish a framework that makes regulatory capital requirements more sensitive to differences in credit-risk profiles among banking organizations. The new guidelines assign all categories of housing-related credit to specific risk-weight categories and thereby, in effect, specify the amount of capital that creditors need to fund outstanding balances on home equity loans and on the undrawn portions of credit lines. (13). The Competitive Equality Banking Act of 1987 was enacted on August 10, 1987; implementing requirements under Regulation Z were adopted on November 3, 1987. The Home Equity Loan Consumer Protection Act of 1988 was enacted November 23, 1988; proposed amendments to Regulation Z to implement the act were published by the Board for public comment on January 23, 1989. (14). Press release, "Risk-Based Capital Guidelines," Federal Reserve System, January 19, 1989.
Competitive Equality Banking Act of 1987
The CEBA requires creditors to place a ceiling on the life-of-loan interest rate on adjustable-rate mortgages (ARMs). However, the statute does not specify any particular rate ceiling, leaving that choice to the discretion of the creditor, or, in some instances, to determination by the applicable state usury law. With respect to home purchase loans, the CEBA has had relatively little effect, since nearly all ARMs had life-of-loan ceilings before the statute's enactment. Virtually none of the credit line plans set up before the effective date of the CEBA included a ceiling on finance rates. Now any newly established home equity line with an adjustable interest rate must carry a rate ceiling.
It is difficult to assess whether the CEBA has had a meaningful influence on the market for home equity loans. However, at least some creditors have emphasized their relatively low ceiling rates when promoting their credit line accounts. Ultimately, competitive forces will determine the level of the rate ceiling a particular creditor needs to establish (given the other features of its product) to maintain its share of the market. Whether such ceiling rates will be low enough to significantly reduce the interest rate risk of borrowers is yet to be seen. Moreover, because creditors will find it more difficult to modify terms and conditions on home equity lines owing to the enactment of HELCPA, they may be reluctant to lock themselves into long-term contracts with relatively low rate ceilings.
Home Equity Loan Consumer Protection Act of 1988
Before the enactment of HELCPA, home equity credit plans were treated like other types of open-end credit plans for purposes of account disclosure and advertising rules under Regulation Z. For instance, as for other open-end loan products, disclosures for home equity lines of credit had to be provided to the consumer before the first transaction. However, borrowing limits on home equity lines typically are much larger than those on other types of open-end loan products, and home equity lines entail a security interest in the consumer's home. Thus, home equity lines tend to expose the consumer to more financial risk than other open-end products do. In addition, a perception existed among some industry observers that certain common features of contracts for home equity credit lines, such as the right to change unilaterally the terms and conditions of the plan at any time, were inherently unfair to consumers. In response to these concerns, rather than to any record of industry abuse of consumers. Congress enacted the HELCPA. The act expands the coverage of rules on disclosure and advertising for home equity lines, requires the distribution of an information brochure about them, and places a variety of substantive restrictions on contract terms and conditions.
The new disclosure rules, along with the information brochure that must be provided to loan applicants, may help consumers to better understand the potential benefits and risks of using home equity lines of credit. The timing of the distribution of the disclosure material to consumers, along with requirements for more complete advertising about the costs of credit line accounts, should facilitate credit shopping. Nonetheless, the extent of these benefits appears limited. First, as noted, consumers who obtain home equity credit lines tend to be financially well-endowed and better educated than most other consumers and thus are probably already better able to understand the potential benefits and risks.(15) Moreover, consumer surveys have consistently found that credit line holders believe they received adequate information about their accounts when they opened them. Second, surveys indicate that only about one-third of credit line holders considered applying for an account with a lender other than the one they ultimately selected and thus did not shop extensively for their accounts. Together, these findings suggest that if future holders of home equity credit lines are similar to those who have already established such accounts, then the new disclosure rules are likely to have limited effects. (15). For example, as the consumer surveys reveal, holders of home equity lines are well aware that serious consequences (including the loss of their home) are associated with failing to repay loans as scheduled.
As mentioned, HELCPA contains several substantive limitations on the way credit line plans can be structured. First, the act requires creditors offering plans with variable interest rates to select an index rate that is publicly available and beyond the control of the creditor. In effect, this requirement prohibits creditors from using an index such as an internal measure of cost-of-funds or their own prime rate, which roughly one-quarter of creditors have used in the past. Second, the statute prohibits creditors from terminating an account and accelerating payment of the outstanding balance before the scheduled expiration of the plan. However, the law protects creditors by providing three exceptions to this rule. A creditor may terminate a plan if (1) there has been fraud or material misrepresentation by the consumer in connection with the plan; (2) the consumer has failed to meet the repayment terms of the agreement; or (3) the consumer acts in a way that adversely affects the credito's security interest. Whether the safeguards afforded creditors in the statute will prove adequate remains to be seen and may depend on future court decisions that will further clarify appropriate situations in which creditors may curtail operations of their home equity line programs.
The final substantive limitation provides that creditors may not unilaterally change the terms of a home equity line after an account has been opened.(16) However, the proposed regulation would allow the creditor and consumer to modify a plan after it starts by using a bilateral written agreement. Such agreements offer both parties an opportunity to make mutually beneficial changes to plans as circumstances change over time.
Capital Adequacy Guidelines
In recent years, federal banking supervisors have assessed the adequacy of the level of bank capital by comparing a bank's ratio of primary and total capital to total assets with minimum standard ratios. On December 16, 1988, the Federal Reserve Board approved new capital guidelines. The guidelines attempt to take explicit account of differences in credit risks among banking organizations' assets and off-balance-sheet items by assigning each type of asset and off-balance-sheet exposure to one of several broad risk categories.
Outstanding balances on both home equity lines of credit and traditional home equity loans that are not first liens will be assigned a 100 percent weight for purposes of calculating risk-weighted assets. Those that are first liens will be assigned a 50 percent weight, provided that such loans have been made with prudent underwriting standards, have sufficient homeowner equity, and are performing in accordance with their original terms. Undrawn portions of home equity credit lines will not be assessed a capital charge if two conditions are met: first, that the bank can terminate the account, prohibit additional draws on the line, or reduce the credit line in accordance with the provisions of applicable federal statutes (at this time, the HELCPA); and second, that the bank reviews the status of the account at least annually. If these conditions are not met, undrawn portions of home equity lines are effectively assigned a 50 percent weight for purposes of calculating the amount of risk-weighted assets. Given the large volume of undrawn credit lines available to consumers (roughly twice the current level of outstanding balances), significant capital charges could be incurred by creditors if the fail to conform to these conditions.
APPENDIX: SURVEY OF CONSUMER
To obtain information on the prevalence of home equity accounts and their use by homeowners, the Federal Reserve Board helped to develop questions that were included in the Survey of Consumer Attitudes for July through December 1988, conducted by the Survey Research Center at the University of Michigan. Interviews were conducted by telephone, with telephone numbers chosen from a cluster sample of residential numbers. The sample was chosen to be broadly representative of the four major regions--Northeast, North Central, South, and West--in proportion to their populations (Alaska and Hawaii were not included). For each telephone number drawn, an adult from the family was randomly selected as the respondent. (16). Unilateral changes that are unequivocally beneficial to the consumer, such as a reduction in an annual fee, would be permitted. Moreover, under certain circumstances creditors may freeze a consumer's access to an account or reduce the available credit line.
The survey defines the family as any group of persons living together who are related by marriage, blood, or adoption, and any individual living alone or with persons to whom the individual is not related. The head of the family is defined as the individual living alone, the male of a married couple, or the adult in a family with more than one person and only one adult. Generally, when there is no married couple and more than one adult, the head is the person most familiar with the family's finances, or the one closest to age 45. Adults are persons aged 18 years or more.
Together the surveys sampled 3,010 families, 2,011 of whom were homeowners. Overall, 109 homeowners reported having a home equity line of credit, and 114 homeowners indicated they had a traditional home equity loan. The survey data have been weighted to be representative of the population, thereby correcting for differences among families in the probability of their being selected as survey respondents. Estimates of population characteristics derived from samples are subject to errors based on the degree to which the sample differs from the general population. Table A.1 indicates the sampling errors for proportions derived from samples of different sizes.
Table : Short-and medium-term interest rates on U.S. Treasury debt
Table : 1. Sources of home equity loans
Table : 2. Characteristics of homeowners, by debt status1
Table : 3. Proportion of homeowners with home equity loans, by demographic characteristic1
Table : 4. Outstanding balance on home equity loans
Table : 5. Purpose of home equity borrowing, by type of loan1
Table : 6. Advantages and disadvantages cited by holders of home equity loans, by loan type.
Table : A.1 Approximate sampling errors of survey results, by size of sample1
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|Author:||Luckett, Charles A.|
|Publication:||Federal Reserve Bulletin|
|Date:||May 1, 1989|
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