When the real estate market was booming, millions of homeowners suddenly found themselves "house rich," using home equity lines of credit to cash in on their homes' growing values, and financing everything from remodeling projects to vacations. But now, people with a line of credit may be in for a surprise: Lenders are blocking the money pipeline, refusing to loan borrowers any more money. In this column, The Early Show's resident financial adviser, Ray Martin, explains why it's happening, and what recourse homeowners have.
The temperature isn't the only thing freezing this winter. Many consumers are experiencing a freeze on their existing credit lines - a process that cancels your available credit and prohibits you from making additional draws against any unused credit line.
Although you don't need to feel sorry for them, banks and credit card companies are having a very tough time right now. As they experience increased defaults on sub-prime mortgages, credit cards and other loans, many banks are scrambling to limit any additional losses.
In the past, when a borrower was flagged as an increased risk, lenders typically took steps to protect themselves. What's happening now is the same, only different. It used to be that the most frequently-used tactic was to trigger "universal default" -- a practice of hiking the borrower's interest rates and fees when the lender detected a payment was late on another, unrelated account. But, now that Congress is scrutinizing the practice of universal default, credit card companies and banks are turning to other strategies to reduce their exposure to more delinquent loans.
In a recent mailing, Countrywide Financial notified 122,000 customers that they may no longer draw on their credit lines that are secured by their home. Indy Mac Bank, the Pasadena, Calif.-based wholly owned subsidiary of Indy Mac Bancorp, Inc., whose slogan is "raising your expectations," dealt a blow to the expectations of thousands of its customers by sending them letters notifying them that their home equity credit lines were "temporarily frozen." Other banks are reported to be doing the same or actively considering this tactic.
Message boards are filled with vitriolic messages that indicate just how frustrated folks are over the actions the banks are taking. Many ask if this is legal. Unfortunately, the answer is "Yes." Most home equity line agreements contain provisions that address suspension, termination, or reduction of credit limits. A typical provision will state that, if the value of the dwelling declines significantly below its appraised value, the lender can refuse to make additional extensions of credit, or reduce the existing credit limit. And even it a credit line is frozen, all payments of interest and principal on amounts already borrowed still have to be paid on time.
The banks' position is that home equity loans are a more risky loan than a first mortgage, because home equity loans are considered second-mortgage loans. So, when a borrower defaults and the home is foreclosed on, the first mortgage gets paid off and, in the unlikely event there is anything left over, it is paid toward the second mortgage. With record-breaking volumes of foreclosures, lenders are concerned that these home equity credit lines may not be paid back.
Just how does a financial institution decide that the value of your home has "declined significantly?" Some banks claim to use an "automated valuation method," or AVM, to determine that homes in certain regions no longer have sufficient equity to secure their recovery of borrowed funds in the event of a possible foreclosure. Home values in local markets can also be a factor. According to a Bank of America spokesperson, if an area has had significant home-price declines over two straight quarters, the loan-to-value limits allowed for home equity credit lines can be significantly lower.
There are two major problems a frozen credit line creates for affected people. First: Financial plans can be significantly disrupted. If you were planning to draw on the credit line to pay for a child's college tuition due later this year, you will not have that option. Another problem is that your credit score will likely take a significant hit. Since you are now using most of your available credit, your credit score can dive, making it hard to qualify for affordable credit to replace the amount that was frozen. Affected people are reporting that their credit scores are falling by as much as 40 to 60 points as a result of credit line freezes.
If you have a home equity credit line and are concerned about a possible freeze, here are a few actions to consider:
Read Credit Line Agreement: Most credit line agreements contain provisions that address termination, revocation, suspension, or reduction of the available credit line. The typical conditions that trigger such action include a decline in the value of the home below the appraised value. Also, if the bank believes there is a material change in your financial situation -- loss or reduction of income due to a job change,for instance - it can freeze or suspend your credit line. Make sure you comply with any requirements to notify your bank if you have changed jobs.
Contact Your Lender: Inquire about the current status of your account and if the bank has any plans to send credit line freeze notices out to its customers. Often, this process can be in the works for several weeks before notices are sent and you may get some advance warning if you contact them first.
Draw on Your Credit Line Now: If you have an available credit line and you will need to draw from it sometime this year, it would be advisable to take the withdrawal now, while you still can. Deposit the withdrawn funds in an interest-bearing bank account or a bank money market fund account, so it will be available when it is needed.
If you have a home equity credit line and have recently received a notice that it has been frozen, here are a few actions to consider:
Challenge the AVM: Some lenders, including Countrywide, have stated that those whose credit lines were frozen due to the results of their automated valuation methods (AVMs) may challenge the value of the home they are now using. The challenge process would include obtaining an appraisal from a firm that would be accepted by the lender, and would involve additional time and expense.
Request a Refund of Fees: Since the credit line for which you have paid fees has been revoked or suspended, it is only fair that any fees you have paid for application and approval of the credit line be refunded. While this is not a requirement, some folks have reported that, when asked, their banks are agreeing to do this.
Consider Refinancing to a Fixed Rate Mortgage: It may be advisable to refinance both the first and second mortgages into a new first mortgage at a fixed rate. That would lock in the interest rate on both loans to a new, fixed rate, at current rates, which are quite low. Of course, this assumes that you will qualify for a new mortgage. But, as a result of the mortgage relief programs that are being rolled out, more people may qualify to do this.