There is a simple truth about the housing market; people are going to buy and sell homes when is suits their life’s circumstances. Unlike many of the readers of this blog, few base their decisions on market dynamics, and even when they do, each sets their own risk parameters.
The main factor separating those who benefited from the housing bubble from those who did not was a Simple Twist of Fate; for some it was time to sell or buy, and Fate either enriched or destroyed them.
I have often wondered if I had made different decisions during the bubble if I would have been caught up in the frenzy. Although I don’t believe I could have fully ingested kool aid, I probably would have behaved like most of my cohorts and increased my loan balance. I consider those who did this with fixed rate financing and still managed to lower their payments as the sly ones. That is as far as I would have gone, but I probably would have taken some of the free money.
The conditions that spawned the rally of The Great Housing Bubble are gone, and we will not see rapid appreciation and a HELOC-fueled economy for decades. I believe we are embarking on a 20-30 year cycle of slowing rising interest rates as we stay one step behind inflation the entire journey. In an environment of increasing financing costs, mortgage equity withdrawal is rare because there is little equity available, and the cost of accessing and spending that equity is high — the opposite of what people have become accustomed to over the last 20-30 years.
It is important to me for people to realize HELOC spending is not coming back. Many buyers operative today are basing their decisions on poor information, they believe that if they can just get into a home, they will get to live off the HELOC money like everyone did in the 00s — they may have to wait a few years, but most buyers are certain HELOC money is on its way. It’s not. As long as buyers are making buying decisions based on poor information, they will likely overpay and be unhappy with the results later on.
I was looking back on the abundance of HELOC abuse stories from last year, and since I know we are going to see many, many more of these disasters over the next several years, I have developed a simple grading system that will tell you at a glance information about the borrower. By devoting this post to the grading sysem, in the future when you see a small graphic that labels the owner a “Grade D HELOC abuser,” you will know a great deal about how they lived and how they managed their debt.
As I contemplated a grading system, I wanted something visually intuitive so I developed the graphic above. The origin point to the left represents the total loan balance on the day the property was purchased. The lines emanating from the origin extend to the right with an angle of trajectory that either pays down a mortgage or adds to it.
Each HELOC grade is separated by a psychological or behavioral threshold, and each one has observable results — you can compare the current mortgage balance with the original one and see how quickly the debt went up or down.
Most people who borrow money do so because they need it. There is a limitation to how quickly they can repay the money, and the limit at the bottom of Grade A is the pinnacle of borrower prudence.
I probably shouldn’t call this HELOC abuse at all because in order to earn an A, a debtor must pay off a mortgage faster than a 30-year amortization schedule. This should not be a difficult hurdle to jump over; in fact, prior to the housing bubble, most borrowers were forced to toe this line by conservative lenders.
The major difficulty in earning an A comes from deferred maintenance and renovation. People tend to borrow for major improvements with the justification it adds value to the property. Added value is debatable, but added debt is certain. Few people pay down their mortgage faster than a 30-year rate, and fewer manage to maintain that trajectory. Kudos and special recognition are in order for those who accomplish this difficult task.
Earning a B in this system requires a debtor to at least hold the line on the total debt. Anyone who does better than treading water — which puts all interest-only borrowers on the line — can earn a B. As previously noted, prior to the bubble, few borrowers were near this threshold and most of the market earned a B for debt management.
Since lenders lost billions allowing copious amounts of mortgage equity withdrawal, since prices are no longer rising, and since the cost of money (interest rates) is likely to rise, borrowers of the future will be forced to earn a B as lenders drop their C, D, E and F customers.
Earning a B is a badge of honor; the scarlet letters are coming next….
I hate to give borrowers in this category a “passing” grade, but this is the reality for most Americans. Growing credit card or mortgage debt slowly generally can be compensated for through home price appreciation, and although I consider this a bad idea, I can’t really call it HELOC abuse, just foolish HELOC use. Is there a distinction there? I will let you decide.
Financial planners will tell you that most people fail to budget properly for unexpected expenses (they don’t save), so when they fall behind a little each month, they put the balance on a credit card and hope they can pay it back with a tax return — or during the bubble with a visit to the housing ATM.
People are still going to manage their bills this way going forward, and there will be pressures to “liberate” this equity to pay for these expenses. The money changers will continue to peddle this nonsense as sophisticated financial management. It is a stupid way to manage debt, and I give it a C.
The transition between a grade C and a grade D is somewhat subjective, but it is hinged to an idea; once borrowers start knowingly increasing their loan balance to spend appreciation as a matter of habit, once they start expecting appreciation and HELOC money as a reliable source of income, they have moved from what some may consider legitimate use of HELOCs to Ponzi Scheme financing and ultimately a foreclosure implosion. This Ponzi borrowing limit is an invisible threshold borrowers do not realize they have crossed, but once they accept using debt to pay debt as a concept, they have crossed over to the Dark Side.
The top of the range of D graded HELOC abusers is the limit of each borrowers self delusion when it comes to how much appreciation they feel comfortable spending without losing their homes. People who earn a D still planned to keep their homes, they were merely misguided by their own ignorance and the incessant Siren’s Song of kool aid intoxication. These are the sheeple; like the rats St. Patrick cast into the sea, each borrower followed the Piper to their underwater mortgage and a watery foreclosure.
Most of the HELOC abuse posts I have done have been Grade E abusers because they are entertaining. When someone borrows and spends a $1,000,000, it is dramatic, and as an outside observer, you have to wonder what they spent all that money on.
Somewhere beyond the limit of self delusion, a borrower makes another psychological leap, they no longer worry about the consequences of their actions and they spend, spend, spend. This grading category spans the continuum from thoughtless spending to foolish and reckless spending where the borrower exercises no restraint at all.
HELOC abusers who get an E had to make an effort to spend. It takes time and effort to really spend beyond ones means one small transaction at a time. How many dinners out, trips to Vegas and other indulgences does it take to consume $1,000,000? I don’t know, but grade E abusers try to find out.
Grade F HELOC abusers are the creme de la creme of their craft. These people are not maxing out their debt to spend recklessly — although I am sure much reckless spending occurred — grade F HELOC abusers are openly gaming the system to flip properties or strip equity while passing the risks on to lenders.
Another group that falls in this category are the Land Barons, as they are described at the Coto Housing Blog. People who stripped the equity from one property to acquire others build a massive Ponzi structure. Back in February of 2009, I profiled the holdings of one such land Baron in Everybody Wants to Own the World.
The upper limit of this boundary is determined by lender greed as reflected through their underwriting standards. During the housing bubble, this line was pushed so far as to create categories C, D, E and F. Since most of these people are going to lose their homes, expect to see lenders lower the trajectory of this line significantly.
Grade F HELOC abusers are the ones who benefited the most from the housing bubble. All Grade D, E, and F borrowers either have or will lose their homes. The grade F borrowers got to extract the most value out of their equity before the market collapsed. Any borrower who had any psychological restraint — even the clueless ones who get an E — are worse off than those who spent with the greatest abandon.