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As Draw Periods Close, HELOCs Present Elevated Threat

clock-and-moneyNow that so many of the once-popular home equity lines of credit (HELOCs) are coming due [1], many borrowers could be in for what TransUnion [2] calls "payment shock."

A new study [3] by the credit reporting agency shows that nearly half of all HELOC balances at the end of 2013—totaling about $474 billion—were originated between 2005 and 2007. Many of these HELOCs had 10-year draw periods, which means that the bill will come for those borrowers over the next few years.

The problem, however, is not the tab itself, but the shock borrowers may get when they see how much their bills are now that they've reached their end-of-draw periods (when no more money can be borrowed from the line) and how quickly the interest adds up to higher payments.

"The financial shock associated with a HELOC payment increasing to cover both principal and interest can cause liquidity issues for some borrowers," said Steve Chaouki, head of financial services at TransUnion. "This dynamic is driving significant concern in the lending marketplace."

According to TransUnion, as much as $79 billion of those outstanding HELOC balances could be at elevated risk of default in the next few years.

"[A]n understanding of consumer cash flows is at the heart of determining if someone can manage a larger HELOC payment each month, and how much larger that payment can grow before the consumer runs into liquidity constraints," said Ezra Becker, co-author of the study and vice president of research and consulting for TransUnion.

According to the study, consumers with sufficient equity in their homes could avoid HELOC default, given that they would have greater options—refinance the line of credit or sell the home.

Key for borrowers is to understand the interaction between home equity, their options, and their cash flow. For example, a consumer might have a high credit score but lack the ability to absorb payment shock. Such a consumer may demonstrate a higher risk of HELOC default after end-of-draw than a consumer with an equivalent high credit score but with ample cash flow to withstand a new payment structure.

Lower debt all around, of course, will also help borrowers mitigate some of the payment shock, Becker said. But that's not very likely right now.

"The vast majority of the nearly 16 million consumers with a HELOC carry other forms of debt as well," he said.