As summer swelters across the U.S., so does the credit crunch. Many banks are putting home equity loans and HELOCs in the deep freeze, locking down home equity credit. Homeowners trying to continually tap their home equity now have severely limited options and solutions.

Housing heated up earlier in this decade, and homeowners and bankers both cashed in on the real estate equity boom. Higher home prices translated into higher equity values, and homeowners during the last bull market didn't just sit on those paper profits-they converted them into spendable income through convenient home equity loans.

Bankers and mortgage lenders created a host of new products to cater to the emerging paper-rich demographic of customers, and they encouraged borrowing by lowering interest rates, closing costs, terms, and application requirements, while simultaneously raising the amounts they would lend. They encouraged appraisers-sometimes unethically and illegally-to puff up home values, and the hotter the market got, the more cold cash they offered to borrowers. Consumers pulled value from their homes in the form of second mortgages and HELOC loans, and spent it on everything from prudent home improvements to imprudent fashion accessories and nights on the town.

Disappearing home equity loans

With value stripped from homes through loans, a dip in prices was potentially problematic. Instead, we got the biggest residential real estate equity meltdown catastrophe in history. Now, lenders are shoring up their reserves-if they have any left to sandbag-by withdrawing credit. Millions of consumers received letters this year informing them that their generous lines of credit no longer exist, have been frozen, or have been slashed by as much as 40 percent.

Solutions to the dilemma

Faced with the sudden elimination of credit, consumers have few options:

  • They can appeal the lender's decision by showing convincing current appraisal data, but that strategy rarely works and takes time to slowly move through lender channels.
  • They can shop for a new lender, but almost all banks are shrinking their lines of credit.
  • If they still have an open line of credit, they can make a maximum withdrawal before it's too late, but they'll have to pay interest on the money.
  • They can do the unthinkable, and cut back on their household budgets by not spending as much, especially on non-essential or luxury items.

Ironically, many consumers interviewed by reporters in the wake of the HELOC changes seem to regard home equity as a liquid asset. In the past, most Americans understood that home equity is 1) hard to get to, and 2) using it can jeopardize one's home as collateral that can potentially be repossessed by a lender. Nowadays, however, many borrowers use-and define-home equity as "cash reserves" or "liquid assets." They fail to understand a basic truth of economic science. Like the liquid that we're most used to-water-it, too, can be frozen. Worse yet, if the heat continues to be turned up, this "liquid" asset can turn to vapor during a meltdown, and totally evaporate.

Published on July 2, 2008