Advice to stop paying on home equity credit line is risky at best
WASHINGTON — Are you delinquent on your first mortgage but still making monthly payments on your home equity credit line or second mortgage?
If so, a finance and real estate professor from DePaul University has some controversial advice for you: Stop paying on your second immediately.
Rebel Cole thinks you are throwing good money after bad.
If you are seriously delinquent on the first mortgage, you're likely headed for foreclosure unless both of your lenders agree on a modification or principal reduction plan. But since you continue to make payments on the second, the bank that holds that revenue-producing note may have minimal motivation to participate in a workout, he believes. Cole estimates that between 1 million and 3 million homeowners are in this position nationwide — so it's a big problem.
By abruptly stopping payments, Cole said, you will force the bank that owns your second mortgage to set aside significant additional capital for loss reserves. Contrast that with that bank's current situation: It gets to report your home equity loan as "performing" for accounting purposes, requiring no extra capital allocations, he said. This is despite the fact that the delinquent first mortgage — which takes payoff priority over the second and may well be underwater — probably renders the true market value of your home equity loan around zero in any foreclosure.
Once the bank is forced to set aside additional capital — as high as 100 percent of the face amount of your equity line — "it starts to really feel pain," Cole said in an interview. Now you should find it more willing to negotiate with you and your first mortgage holder to work out a loan modification, principal reduction or short sale. And if not, simply bank the money you'd otherwise be paying on the second mortgage.
It may take a year until a foreclosure filing, and 350 days or more, depending upon your location, before you actually have to vacate the house. Meanwhile you'll be saving money every month.
Sound like a smart financial strategy? Cole has been pushing the idea in analysis and opinion articles, but what are the real pros and cons for consumers?
Start with the core idea that banks will be vulnerable to big hits to capital for loss reserves if you stop paying on your second mortgage — thereby softening them up for principal reductions later. That's not likely to happen, according to banking executives and financial regulators, because current federal loss-reserve rules already require institutions to proactively set aside additional reserves on seconds once there is any hint that the associated first mortgage is in distress — whether through delinquency, a loan modification or other indications.
Also, Cole's estimate of as many as 3 million homeowners with paid-up seconds but delinquent firsts appears to be far overstated, according to new data from the Office of the Comptroller of the Currency. Recent bank examinations found that about 235,000 second liens may be in that position — a substantial number, officials concede, but nowhere near Cole's estimate of the size of the problem.
Even more important, the personal impact on you when you stop paying a second lien could be severe. Your credit scores will definitely take a hit. Since you're behind on the first loan, your scores are probably depressed already. But stiffing the lender on your second mortgage will push them down even more, further limiting your access to credit in the future.
Worse, in some states, even if you go through foreclosure, the bank could legally pursue you for full payment on the face amount on the unpaid second. The bigger the outstanding home equity loan, the more likely the pursuit.
Asked for comment, federal financial regulators bristled at Cole's proposals. Timothy Long, senior deputy comptroller of the currency, called the professor's recommendations misguided.
"That kind of advice to borrowers is dangerous," Long said in an interview.
Top officials of major banks generally were reluctant to talk on the record about Cole's ideas, but Dan Frahm, a Bank of America spokesman, said his company's "approach has been not to let second lien issues prevent us from modifying" mortgages, including "making principal reductions, even when the second lien is owned by a third-party investor and has not been modified." The bank also said stopping payment on a second would not enhance a borrower's chances of a modification or principal reduction.
Bottom line: Follow professor Cole's advice at your own peril. There is little evidence it will be effective in convincing your lender to do anything.
Ken Harney can be reached at email@example.com.