Home equity loans and the business cycle

Business Economics, Jan, 1989 by John E. Silvia, Barry Whall

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.

STATISTICAL RESULTS

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)