Recent developments in home equity lending - includes related articles on consumer satisfaction survey and estimate of aggregate debt

Federal Reserve Bulletin, April, 1998 by Glenn B. Canner, Thomas A. Durkin, Charles A. Luckett

Glenn B. Canner, Thomas A. Durkin, and Charles A. Luckett, of the Board's Division of Research and Statistics, prepared this article.

The equity that has accumulated in homes is one of the largest components of U.S. household wealth. But unlike many other types of assets, home equity is not highly liquid--it cannot, for instance, be readily used to purchase goods or services or to repay debt. Home equity is, however, a widely accepted form of collateral for credit, and in recent years, homeowners have borrowed large amounts against the equity in their homes.

Home equity borrowing is frequently used as a substitute for consumer credit, either to finance new consumption expenditures or pay down outstanding consumer debt. This substitution generally lowers the interest expense of carrying debt and may further reduce monthly debt service payments in the short run by lengthening loan maturities. Of course, by replacing what is often unsecured debt with homesecured debt, borrowers become exposed to the risk of more severe consequences in the event of some financial setback that might impair their ability to service their debts.

In view of the growing importance of home equity credit in household finances, the Federal Reserve has for a number of years closely followed developments in the home equity lending market. The Federal Reserve obtains information from monthly and quarterly reports from banks and other lending institutions, and it has participated in several nationwide surveys of household finances, including some that focus on the use of home equity loans.(1)

Most recently, to learn more about the current status of home equity lending, the Federal Reserve participated in the May through October 1997 Surveys of Consumers, a monthly canvass conducted by the Survey Research Center of the University of Michigan (for further details on the surveys, see the appendix). This article presents findings from those surveys and from other sources of information on home equity lending.

BACKGROUND

Home equity credit is only one way homeowners can convert their home equity (which is the difference between the home's market value and its outstanding mortgage debt) into spendable funds. Homeowners may sell their homes and purchase less expensive property or become renters. Alternatively, a homeowner may refinance an existing mortgage and borrow more than is required to pay off the old loan plus closing costs.(2) The availability of these alternatives greatly influences the home equity credit market. Refinancings, which are apt to occur in large volume when interest rates fall, particularly affect home equity lending because homeowners often pay off other debts, including home equity loans, when they refinance an existing purchase-money Mortgage.(3)

Home equity credit typically takes either of two forms. One, referred to here as a "traditional home equity loan," is a closed-end loan extended for a specified length of time and generally requires repayment of interest and principal in equal monthly installments. Such loans typically are second mortgages. Interest rates on these loans are ordinarily fixed for the life of the loan. The second form, a "home equity line of credit," is a revolving account that permits borrowing from time to time at the account holder's discretion up to the amount of the credit line. Home equity lines of credit typically have more flexible repayment schedules than traditional home equity loans, and the interest rates on most of these loans vary with changes in an index rate, such as the prime rate.(4) The majority of credit lines are also of second-mortgage status, but they would be first liens for homeowners who had no other mortgage debt outstanding when the lines were established. The survey results indicate that the users of these two distinct types of home equity products themselves differ in measurable ways.

At the end of 1997, the outstanding home equity debt of U.S. homeowners was an estimated $420 billion, an amount that is fully one-third the size of nonmortgage consumer debt. Home equity lenders have been expanding their product offerings and changing underwriting standards as they have gained experience with the market. Lenders have continued to promote this product aggressively by waiving closing costs and other fees, offering low introductory interest rates, and increasing the acceptable limits on loan-to-value ratios.

HOLDINGS OF HOME EQUITY LOANS

Although households have used home equity loans for many years, their appeal for homeowners was heightened by the Tax Reform Act of 1986, which mandated the phaseout of federal income tax deductions for interest paid on nonmortgage consumer debt. With this change in tax law, mortgage debt (on which the interest remained tax deductible) became more attractive to consumers for funding expenditures that previously were financed through auto loans, credit cards, or personal cash loans.

The favorable tax treatment of debt secured by homes, however, is only one reason for the popularity of home equity loans (table 1). Consumers also frequently cite the relatively low interest rates on home equity loans compared with most other forms of consumer credit as another important advantage.