This piece originally appeared in the February 2024 edition of MortgagePoint magazine, online now.
In the ever-evolving landscape of the U.S. housing market, American homeowners may choose to use a home equity line of credit, or HELOC, over refinancing their current mortgages or purchasing new homes.
Equifax data showed that through June 2023, around 617,000 HELOCs originated, equaling $75.4 billion year-to-date in total credit limit.
A HELOC is a secured loan borrowed against the available equity in a home, with the house serving as collateral for the line of credit. Homeowners have long used HELOCs as flexible sources of funds to address a range of needs, such as home improvements, debt consolidation, educational expenses, investments, or major purchases. HELOCs typically have lower interest than alternatives, such as credit cards, which make for an enticing alternative to some of the high interest rates that have been seen in recent years.
HELOC usage spiked in 2021 and 2022, when the market saw a 39% surge in originations of the loans, and its continued use as an option shows how homeowners are approaching their financial needs.
Several factors are contributing to the desire for HELOCs. First, homeowners benefited from historically low mortgage rates for most of 2020 and 2021, when interest rate averages hovered around 3%. It’s not surprising that homeowners would be hesitant to trade in their advantageous mortgage loan terms to purchase a new home at today’s interest rates, which Freddie Mac’s Primary Mortgage Market Survey (PMMS) reported as being at a 23-year high of over 7% in mid-September. For example, a borrower who purchased a $250,000 home in 2021 at a 3.75% interest rate would pay roughly $1,200 monthly. Fast forward to 2023, and the same house, financed at a 7% interest rate, would require a monthly payment of approximately $1,700. In fact, only 18% of homeowners said it was a good time to buy a house, and only 18% expect mortgage rates to go down over the next 12 months.
Second, the unprecedented increase in home prices over the last few years has resulted in many homeowners gaining unexpected equity in their properties. Home prices soared in 2021, hitting the biggest increase in 34 years, with regions across the United States seeing prices even higher than that of 2020, when many Americans took advantage of low mortgage interest rates. CNN also reported that in the South and Southeast, home prices saw the biggest spikes with averages exceeding 25%. This surge may be attributed to various factors during that same time period, including increased demand for homes, low mortgage interest rates, and a limited housing supply. While some were swept up by the real estate bidding wars, those who stayed in their homes saw a boost in their home values, allowing many homeowners to see substantial increases in their property’s equity.
Today, the U.S. median home price continues to rise, and in August 2023, areas of the country such as Massachusetts were reporting new record highs.
Paired with the low housing supply and current record-high mortgage interest rates, potential sellers are choosing to stay put in their current homes. With a HELOC, homeowners can access this equity without the hassle of selling their home or refinancing. As a result, they can conveniently access incremental funds as needed, only incurring interest on the amount drawn.
But there’s a twist to the increase in HELOCs: the data shows that more HELOCs are being issued to consumers with subprime credit scores (of less than 620.) Originations through June 2023 saw 4.3% of HELOCs were issued to homeowners with subprime credit scores, almost double from the year prior. And unlike conventional mortgages, lenders issuing the HELOC are on the line if a borrower defaults. While traditional credit reports have been the go-to tool for assessing borrowers’ creditworthiness, the HELOC underwriting process necessitates a more comprehensive approach.
Credit reports remain an important tool, but relying solely on them may not provide a complete picture of a borrower’s financial situation. Crucial information such as income, employment stability, and debt-to-income ratios may be missing from traditional credit data.
Incorporating income and employment data from third-party sources regulated under the Fair Credit Reporting Act (FCRA) can help provide lenders with a more comprehensive understanding of an individual’s financial situation, encompassing various income sources such as employment wages, bonuses, commissions, dividends, and more. It can also offer a detailed view of gross income and salary or wages, contributing to a more holistic assessment of a borrower’s financial capacity.
Employment data can also play a significant role in the assessment process. It allows for a truly holistic perspective on an applicant’s work situation, including details like the employer’s name, job title, duration of employment, and employment status (e.g., active, inactive, furloughed, full-time, part-time, or contract). Access to historical employment data spanning months or years helps gauge the applicant’s employment consistency and income stability, which are vital factors in evaluating credit[1]worthiness. These data points, while often overlooked in traditional credit assessments, can play a pivotal role in HELOC underwriting. Lenders can use this information to evaluate a borrower’s ability to repay loans, determine their creditworthiness, and assess their overall financial stability.
The Debt-to-Income Ratio: A Key Metric in Underwriting
Lenders have to properly assess whether the borrower has the financial capacity to add the additional debt to their existing debt load. The debt-to-income (DTI) ratio evaluates a borrower’s ability to repay that debt by comparing monthly debt obligations, including potential HELOC payments, to monthly income. Ideally, lenders seek a DTI ratio below a specific threshold, often aiming for 36% according to Fannie Mae, or 43% according to the Consumer Financial Protection Bureau, to ensure borrowers can comfortably meet their debt obligations.
However, depending solely on borrower-provided information for DTI calculations can pose significant risks for lenders. Inaccuracies or omissions in the borrower’s financial data aren’t uncommon and can lead to incomplete assessments of their creditworthiness. This is where verification of financial data from independent third-party sources can help mitigate the risks and enable more informed underwriting decisions.
By verifying employment status, job title, income, and other relevant details through third-party sources lenders can ensure that the borrower information they have is current. This information can ultimately help reduce the risk of defaults and provide a more complete picture of the borrower’s financial capacity.
Additionally, leveraging income and employment data helps create for lenders a standardized approach to evaluating borrowers. For instance, right now, income is the biggest risk when it comes to mortgages in the current economic state, potentially transferring that risk to HELOCs if full affordability diligence is not completed and creating a larger need for leveraging that data. This promotes consistency in the underwriting process and helps ensure that people with similar income levels and employment statuses are treated consistently.
The Future of HELOCs and Data
The ebbs and flows in HELOCs showcases the tumultuous economic landscape of today, characterized by inflation, soaring home prices, and fluctuating mortgage rates. HELOCs continue to offer a lifeline for homeowners and their evolving financial needs.
However, the HELOC underwriting process may require a more comprehensive approach than traditional credit assessments can provide. Income and employment data offer valuable insights into a borrower’s financial capacity and stability. By leveraging this data, lenders can better reduce risks, enhance consistency in their process, and make more informed underwriting decisions.
As the housing market continues to evolve, lenders must adapt. Incorporating income and employment data into the HELOC underwriting process is a significant step toward ensuring a more stable financial future for both lenders and borrowers. As HELOCs continue to be a financial resource for homeowners, lenders need to collect holistic data in order to make more informed, responsible decisions.
