Home Equity Lines of Credit: The Next Looming Disaster?

A Brief Explanation of HELOCs

A HELOC is quite similar to a business line of credit and has some similarities to a consumer credit card as well. Using the residence as security, a homeowner is given a line of credit with a prescribed limit upon which the borrower can draw at any time.

The homeowner receives a draw period of anywhere from five to 10 years when funds can be drawn. During this draw period, the borrower is usually required to pay interest only. The rate is adjusted monthly and is pegged to the prime rate. The repayment period is typically 10 to 20 years. The monthly principal payment is usually the outstanding balance at the end of the draw period divided by the number of months in the repayment period.

Because qualifying standards were based primarily on the equity in the home, HELOCs became nearly irresistible in those states where prices were rising rapidly in 2004-2005. Homeowners discovered that their home had actually become a money tree which they could shake almost at will. 

Madness of HELOC Lending During the Bubble Years

Aided by the seemingly limitless desire of banks to lend money, homeowners opened an incredible number of HELOCs during the bubble years of 2004-2006. 

Nowhere was the madness of HELOC-borrowing more astounding than in California. During the two key years of 2004 and 2005, a total of 1.43 million HELOCs were originated in California just for the purchase of homes, according to figures received from CoreLogic. 

"Wait a minute," you say. "That's more than the total number of homes sold in California during these years." Correct. A total of 1.25 million existing single-family homeswere purchased in California in 2004-2005 according to the California Association of Realtors. 

At first, these California HELOC numbers may be a little puzzling. However, they make sense when you consider the speculative mania that occurred during the bubble years. In my earlier article about investor speculation, there was an example of caravans filled with out-of-state speculators looking to buy investment properties in Austin. One was a young Californian who had sold a few of his Phoenix investment properties so he could roll his profits into Austin homes.