Trouble in Paradise

During the recent credit boom, homeowners used equity in their homes as an ATM . Most homeowners used home-equity borrowing to make home improvements. However, nearly one-third of home equity borrowers spent their home-equity cash on debt consolidation.

Bad move. The biggest home equity lenders are calling in home equity loans in response to the decline in home values and tightening of avaliable capital for home mortgage investment. Washington Mutual (WaMu), one of the biggest home equity loan investors, announced in May 2008 that it had reduced or suspended about $6 billion of available credit under existing home equity lines. Countrywide, Bank of America and JPMorgan Chase have made similar moves. As home values decline, loan to value ratios turn against homeowners. Under the terms of home equity loans, lenders have the right to cap the loan balance to reflect the current ratio. For example, suppose a homeowner qualified for a $25,000 home equity line three years ago based on a home value of $250,000. She draws down $10,000 to finance a vacation in Bali. When her home value drops to $200,000, the bank caps her home equity line at $10,000. The homeowner cannot find another lender to replace the $15,000 in credit she lost. Worse, the she's "maxed out" the newly configured equity line. The bank will report this as a negative event to credit reporting agencies.

But wait, there's more. A home equity line of credit is secured by a lien on the debtor's principal residence. In contrast, credit card debt is unsecured. Our homeowner feels the drop in her credit score and no prospects for paying off her consumer debt. She might contemplate filing for bankruptcy relief. If she had used her credit card to pay for the Bali vacation, she might be able to discharge the debt in bankruptcy. Not so with secured debt in the form of a home equity line.