Rising default rates are prompting lenders to change their underwriting guidelines, making it more difficult for many to obtain home equity loans and other types of mortgage financing.

In Aldous Huxley's novel Brave New World, character John the Savage is forced into a society he doesn't understand. Homeowners of today can relate to John's feelings of confusion-it seems like the rules of home equity loans have changed recently, and it's leaving some borrowers out in the cold.

Rules changes for home equity loans

As the problems in the mortgage industry continue to play out, lenders are doing what's necessary to survive. They're feeling a two-pronged sting, as the combination of losses generated by defaults and a shorter supply of money impacts current performance and the lending outlook. They're managing the pain by re-evaluating how they lend money. Here are some of the new rules lenders are enforcing on their home equity loan applicants:

1. No more slam dunks. A couple of years ago, it seemed as if all that homeowners needed to obtain approval for a home equity loan was a pulse. Now, the value of the home will be carefully analyzed along with the applicant's income qualifications. Lenders aren't going to be as willing to provide those 100 and 125 percent home equity loans of days past. And applicants will have to prove that they have sufficient income to support the extra mortgage payments.

2. The return of private mortgage insurance (PMI). There was a time until recently, where lenders were helping their applicants avoid the extra cost of private mortgage insurance. Many of these same lenders are probably kicking themselves right now, wishing that they had that extra insurance protection. Piggyback loans, which are essentially 100 percent home equity loans, will no longer be an easy strategy for avoiding PMI. Instead, homebuyers will just have to save up a larger down payment or pay the extra fees for PMI.

3. An end to creative financing. Conservatism is the word of the day. Lenders aren't interested in taking chances right now. That means that every detail of a borrower's qualifications is likely to be reviewed with a fine-tooth comb. When borrowers don't qualify for one loan, there will be fewer secondary options to consider.

In short, all types of home equity loans are harder to get now than they were in the past. Applicants should be ready to provide full documentation of their income and asset qualifications. The approved loan amount will be less than the home's full market value, as determined by a professional appraisal report. Applicants who have less-than-perfect credit can expect to pay bigger premiums for loans, if they can manage to get approved.

It's a new world out there with respect to home equity lending-a world where ultra-conservative underwriting guidelines may leave some homeowners feeling alienated like John the Savage. The only thing to do is rethink those financial strategies, and consider putting off big projects until things calm down again in the mortgage loan market.

    Published on January 6, 2008