A rise in interest rates could put a chill in the suddenly hot home equity market, depriving banks of what has become a major source of revenue. Over the past several weeks, demand for home equity loans has heated up just as the mortgage refinancing market has been cooling off. The switch from refinancing to home equity loans is a big reason many of the nation's banks say they continue to see strong consumer borrowing demand. In the first week of April, the dollar value of home equity loans issued by the nation's commercial banks was $315.4 billion, up 2.5% from the week before, according to the Federal Reserve. For all of this year, home equity loan balances at the nation's biggest banks have risen 12%. By comparison, mortgage-refinancing applications fell 30% during the first week of April, following a big surge in the interest rate on the 30-year fixed-rate mortgage to 5.89%, according to the Mortgage Bankers Association. But some expect a similar cooling off in the home equity market if the Federal Reserve starts boosting interest rates this summer -- something that looks increasingly likely following Fed Chairman Alan Greenspan's upbeat comments on the state of the economy. The worrywarts say home equity loans are much more susceptible to changes in interest rates than other kinds of consumer debt. That's because the interest rates banks charge borrowers on home equity loans are often tied to changes in the prime lending rate, and that rate tends to move in lockstep with fed funds.
"Home equity lines do worry me," says David Wyss, chief economist with Standard and Poor's. "We have had a significant increase in them lately." Wyss says a potential pitfall for banks is if cash-strapped consumers, who've been using home equity loans to buy cars and pay off sky-high credit card bills, start defaulting on those credit lines. In the event of a default, banks often stand to collect little on a home equity loan. That's because the borrower usually also has defaulted on his underlying mortgage and there's nothing left over to cover the home equity line once the house is sold at auction. Others, meanwhile, say the biggest danger to banks isn't so much the threat of defaults, but the drying up of another consumer lending revenue stream. Normally, in a booming economy banks would be able to rely on an uptick in commercial lending to make up for any shortfall in consumer borrowing. But commercial borrowing remains lackluster. So far, most of the banks that have reported solid first-quarter earnings are doing so on the strength of their consumer lending operations. "Home equity has been where the growth is, and that will be the next leg to go for the banks. It has taken over for mortgage and refinancing growth," says David Hendler, an analyst with CreditSights. Hendler says any slowdown in the home equity loan market due to rising interest rates could "put a crimp in bank revenue and bank earnings."
Lenders such as Countrywide Financial ( CFC), Wells Fargo ( WFC) and Washington Mutual ( WM), banks that have made a fortune off the booming mortgage market, could be hit hardest by a slump in home equity loans. But unless the commercial lending market comes back soon, no bank is really immune from taking a revenue hit. Still, banking industry experts say talk about the negative implications of a Fed rate hike on the home equity market is overblown. They say with the fed funds rate at 1%, there would have to be a lot of interest rate hikes before consumers stopped taking cash out of their homes. The current interest rate on most home equity loans is below 4%. "Our view is that there is still a lot of equity out there," says Douglas Duncan, senior economist with the Mortgage Bankers Association. "I don't think you see home equity lines get cut off until the rates go up to 7%."