Does your client have a home equity line of credit (HELOC)? If so, he may be at risk of over-borrowing, finds a report by the Financial Consumer Agency of Canada (FCAC).
FCAC commissioner Lucie Tedesco says HELOCs may lead Canadians to use their homes as ATMs, making it easier for them to borrow more than they can afford.
Borrowers may also be more vulnerable to economic shocks such as a job loss or an interest rate hike.
With debt-to-income ratios at a record high, policy-makers have named household debt as a key risk for the Canadian economy. And the expansion of the HELOC market has been a key driver behind rising Canadian household debt since the 2000s, says the report, citing research by the Organization for Economic Co-operation and Development.
The report also notes that 40% of consumers don’t make regular payments on their HELOC principal, and 25% pay only the interest or make the minimum payment. Further, most consumers don’t repay their HELOCs in full until they sell their homes.
Bad behaviour by the banks?
Though HELOCs have been around since the late 1970s, most HELOCs sold today are components of re-advanceable mortgages, which combine HELOCs with amortized mortgages and other credit products.
“This represents an important shift in both the way HELOCs are sold and how Canadian consumers are financing their home purchases,” says the report, which notes that the number of mortgaged households with a HELOC and an amortized mortgage has increased nearly 40% since 2011.
(At the same time, the number of Canadian households with stand-alone HELOCs — without also having amortized mortgages — has declined by 40%.)
Re-advanceable mortgages are complex. The report finds that many consumers would benefit from more and clearer information about how they work, the applicable fees, terms and conditions, and the potential risks.
Instead, banks are concentrating on marketing re-advanceable mortgages, finds the report. Sales representatives are expected to introduce and sell the products to clients.
In fact, banks reported to FCAC that re-advanceable mortgages are now the default option offered to credit-worthy mortgage customers with down payments of at least 20%. Of the approximate 3 million HELOC accounts in Canada in 2016 (held at federally regulated financial institutions), 80% were held under re-advanceable mortgages.
Potential effects in Canada, real effects in the U.S.
If Canada’s housing market experiences a correction, HELOC borrowers could find themselves underwater, says the report. Their homes would be worth less than the loan obligations secured against them. And, obviously, consumers with negative equity are at an elevated risk of default.
Further, falling house prices would constrain HELOC borrowers’ access to credit, forcing them to curtail their spending, which in turn hurts the economy. And, during a severe and prolonged market correction, lenders might revise HELOC limits downward or call in the loans.
Some economists argue that borrowing heavily against home equity played a significant role in the U.S. financial crisis and subsequent recession. For instance, research shows that homeowners who had borrowed aggressively against the rising value of their homes were responsible for 40% of mortgage defaults between 2006 and 2008.
The FCAC report notes, however, that the U.S. is one of the only high-income countries with no loan-to-value (LTV) ratio restrictions or debt-service coverage limitations on home equity borrowing. That means Americans can borrow aggressively against their homes.
In Canada in 2012, the Office of the Superintendent of Financial Institutions lowered the maximum LTV ratio for HELOCs (offered by federally regulated lenders) to 65% from 80%. Consumers can increase their leverage another 15%, but they must use amortized mortgage products to increase their LTV ratios to 80%.
After the maximum LTV ratio was lowered, the growth of the HELOC market slowed, suggesting the measure contributed to market moderation, notes the report.
But that doesn’t mean Canada can breathe easy. The HELOC market in Canada is significantly larger relative to GDP than it is in the U.S. (11% versus 3%), says the report. And most HELOCs in the U.S. have definite terms, which could “mitigate the risk of debt persistence, credit deterioration and adverse selection.”
Read the full FCAC report.