Home equity loans are harder to come by as secondary market investors rethink their exposure to the struggling U.S. mortgage industry.

Bob, a homeowner who's short on cash, recently came across an old solicitation for home equity credit. He pondered his growing credit card debt momentarily, and then reached for the phone. Expecting a fast-talking mortgage lender to answer, Bob was surprised to hear that the number had been disconnected.

Secondary market demand drying up

What's happening out there? Our homeowner, Bob, doesn't have particularly shoddy credit; he's just a regular guy who's interested in a home equity loan. Unfortunately, Bob's prospects aren't as great as they were a few years ago, and the change has nothing to do with him or even other homeowners like him. Industry dynamics are at work, correcting the over-heated growth of recent years.

That growth was fueled by an excess of secondary market demand for non-conforming loans. These financial instruments fall outside the parameters set by the two federally chartered entities that back mortgage loans, Fannie Mae and Freddie Mac. Home equity loans are non-conforming, as are jumbo loans. Since they have no federal backing, non-conforming loans are riskier and carry higher interest rates. At one time, investors liked them. Now things have changed.

Growing default rates in the subprime sector have prompted investors to rethink their exposure to risky first and second mortgages. Demand has dried up for the subprime category, but it's also dried up for all non-conforming loans. This has become a devastating problem for lenders who rely on the secondary market to replenish their funds. Since investors aren't buying home equity loans, many lenders have been forced to stop offering them.

Credit unions, consumer banks cleaning up

Well-qualified homeowners aren't left without home equity options, however. Not all mortgage lenders rely heavily on the whims of the secondary market. Credit unions and many consumer banks, for example, fund their loans with customer deposits. These organizations are continuing to make first mortgage and home equity loans as they always have, despite the turmoil in the subprime space. For that reason, would-be home equity borrowers might have an easier time getting their loan from a self-funded bank or credit union.

There is a downside, though. Since banks and credit unions have a limited supply of funds, they tend to have more conservative underwriting practices. Homeowners with credit problems may be denied, and banks will be unlikely to lend against 100 percent of the home's value. Credit unions might be more lenient to long-time customers. Everyone else may have to accept the new fact that equity financing is just harder to come by than it used to be.

Meanwhile, our homeowner, Bob, has decided to forgo the home equity loan until the industry calms down a bit. He's managing his credit cards the old-fashioned way, by curbing his spending and paying down as much as he can each month.

Published on September 19, 2007