Home equity loans enjoyed popularity before the housing bubble burst, as Americans tapped their home equity and spent it like it was going out of style. But now, those same home equity loans are a big problem for people who want to do loan modifications to avoid foreclosure.

Many banks are finally cooperating with government officials who have been asking them to voluntarily rework loans. These intentional loan modifications can involve freezing rates, lowering principal, or extending the life of the loan in an effort to lower monthly payments. But the business of loan modification gets much more complicated when home equity loans and multiple lenders are involved.

Loan modification limbo

Investors who funded those secondary loans-and who want to get repaid without concessions and compromises-often have conflicting interests with banks that own the first mortgage. Getting both first mortgage and home equity loan investors to agree to the same set of loan modifications can be an impossible task. While negotiations drag on, homeowners are left with no clear answers. That can leave them in limbo, unable to make clear financial plans. That's because they have no idea whether their loan modifications will be approved. That could mean the difference between losing a home to foreclosure, or staying in the house with a more affordable and attractive loan that's not encumbered by any home equity loans.

About home equity loans

Home equity loans account for more than a trillion dollars of real estate debt in the U.S., and large banks hold most of those obligations. Mortgage lenders aggressively marketed home equity loans during the last real estate bull market as the financial equivalent of having an ATM machine parked on the front lawn. At the same time, they pushed risky first loans with low down payments and dangerously unpredictable interest rates. Now, their efforts have backfired, and because they sold so many home equity products, they may not be able to do loan modifications to salvage their more lucrative first mortgages.

Problems with mortgage loan securities

Making the problem more difficult to solve is the fact that millions of loans were packaged and then resold as mortgage securities. Those loans are now owned by investors all over the world; they may even have sold them to someone else. Sitting down to work out loan modification details is challenging enough, but when the interested parties who stand to lose money if they agree to them are spread all over the planet, it becomes virtually impossible. Home equity loan investors want to get paid before other more senior loans are modified, and that's a huge sticking point. That can leave homeowners in legal limbo as they try to make financial plans, but have no idea whether their loan modifications will be approved.

To help with the impasse, efforts are underway to reach a compromise that would call for first mortgage investors or banks to pay off the investors who hold home equity loans as part of any loan modifications.

Published on January 12, 2009