Introduction to Home Equity Lending Market

By SAM GARCIA

Facing declining originations because of high interest rates, traditional first mortgage lenders -- who are losing more than $2,000 for each loan they make -- are exploring opportunities in the home-equity market. There are three distinct product types for them to consider.

While home-equity products were all but abandoned following the Great Financial Crisis, banks slowly returned -- limiting their offerings to high-quality borrowers.

In 2016, Spring EQ LLC was an early entrant to the second mortgage business, and fintechs like Figure sprouted up in the years that followed. This left the budding sector well positioned to capitalize on an inevitable ascension in interest rates.

In the years leading up to the surge in rates, the traditional mortgage industry -- including originators, investors, servicers and service providers -- built a massive infrastructure able to handle more than $4 trillion in new mortgages during a single year. But when rates were thrust violently higher, first mortgage production dramatically declined.

Some independent mortgage bankers downsized, some closed their doors, and others have dug in and are waiting it out. And there are some who are examining home-equity products.

For homeowners, high interest rates mean that it becomes extremely difficult to sell a home with a sub-4 percent mortgage in place in order to purchase another property and finance it with a new mortgage at today's 6-plus percent rate. And borrowers who are sitting on record levels of equity and want to extract some of that capital have no incentive to disturb their low-rate mortgage through a cash-out first-mortgage refinance.

So, a second mortgage makes more sense for borrowers who want to preserve their existing first mortgage rates.

Because junior-lien loan amounts are far smaller than first mortgages, lenders and investors are more willing to leverage automated valuation models instead of appraisals, title reports instead of title insurance policies, and automated verifications.

Some fintech lenders use big data analytics to approve borrowers who might not qualify for home-equity products at traditional lending institutions.

There are three primary types of home-equity products. The first is a home-equity line of credit. This is an open-end mortgage, often in junior-lien position, that allows the borrower to access additional draws for a fixed number of years up to the maximum credit line. At the end of the draw period, HELOC payments on the remaining unpaid principal balance are amortized for a fixed term.

HELOCs are not subject to the Consumer Financial Protection Bureau's Ability to Repay rule.

Next up are closed-end second mortgages. Also known as a home-equity loan, the product is sometimes referred to as a CES loan, a HEL and a HELoan. These are standard cash-out mortgages that are subordinate to a first lien.

While home-equity conversion mortgages, also known as reverse mortgages, allow for equity extraction, their dynamics are more like cash-out first mortgages in that paying off an existing low-rate mortgage can be cost-prohibitive. The exception here is a junior-lien reverse mortgage -- like those offered by Finance of America Reverse and Loangevity Mortgage -- which allow homeowners to keep their existing low-rate first mortgages in place while avoiding a monthly payment.

A third home-equity product is a home-equity investment. This can involve a range of contracts types. Some require that a lien be filed against the property, others don't. Some have the investor take title along with the homeowner, and others have no such requirements. Some utilize a mortgage, and other don't. Regardless of their structure, they all have one thing in common: no monthly payments.

Other names for HEIs include home-equity contracts, home-equity agreements, HEAs, shared-appreciation mortgages, SAMs and equity-sharing contracts.

Several home-equity third-party originator programs are available for mortgage brokers and correspondent lenders who are interested in home-equity lending. In addition, there are white-label home-equity platforms that enable automated home-equity lending.

Around 1.1 million HELOCs were originated for nearly $150 billion last year, sinking from roughly 1.3 million units for more than $260 billion. Banks are the biggest originators of HELOCs, followed by credit unions.

As bank dominance of home-equity lending has recently been waning, non-bank lenders have been finding growing investor appetite for home-equity bonds. During the first quarter of this year, HELN tracked 10 home-equity bond issuances for over $3 billion, soaring from two deals for less than a half-billion dollars during the same three months last year. Driving the increase was robust CES issuance.

HELOC yields at credit unions were 8.43% during the fourth quarter, while yields were 6 basis points higher at banks. For securitized HELOCs originated around the same time by non-banks, the average yield was 11.09%.

As first-mortgage lenders investigate the pros and cons of home-equity lending, they need to analyze HELOC, CES and HEi products. There are multiple secondary market models to choose from, and investor interest is elevated -- especially for CES product.