Many HELOC lenders have given borrowers too much of an escape hatch from rising rates, in the form of loosely-designed fixed rate options. It is time to review pricing.
As newly-energized home equity lenders sprint toward an expected $80 billion of line originations this year – nearly double the 2012 nadir – a key question is how renewed expansion squares with a potential scenario of rising rates.
On the surface it is a non-issue, given that home equity lines of credit are based on floating rates tied to market indexes. Such spread protection would seem to assure that HELOC lenders can ride out any Fed rate hikes. But many HELOC lenders have provided borrowers with too much of an escape hatch from rising rates, in the form of loosely-designed fixed rate options. Lenders must act quickly to rationalize such options before rates rise appreciably.
Able to move any portion of their outstanding HELOC balances into an amortized fixed rate loan, borrowers surely will take greater advantage of fixed rate options if market rates move. Portfolio managers can suffer if options are mis-priced, however, and our research reveals many instances suggestive of undisciplined FRO pricing.
In a recent Novantas pricing study based on data from Informa Research Services, for example, one major market lender was offering a fixed rate HELOC option for a premium of only 25 basis points over its posted floating rate, compared with a 180 bp average premium for the study group. In another market, a lender was discounting its 10-year fixed rate option by 294 basis points compared with the local average.
Beyond such abysmal extremes, our research uncovered widespread instances of weakly-priced HELOC fixed rate options in various markets nationwide, suggesting that quite a bit of fence-mending is needed. But FRO pricing challenges extend even further than exposure to rising rates.
At the opposite ending of the pricing spectrum, some lenders are potentially undercutting balance formation via sky-high fixed rate offers (300 bp above the norm in some instances). Fee strategies for fixed rate HELOC balance conversion go unexplored, meanwhile, as do possibilities for market-by-market price optimization.
The upshot is that many HELOC lenders need an overhaul of FRO pricing strategy and product management. A potential changing rate environment provides immediate justification, but the big picture is about repositioning the post-recession HELOC market for sustained healthy growth.
Fixed rate options are not new. They were employed well before the financial crisis and continue as oft-used tools to stimulate borrowing, retain balances and drive special rate offers in both rising and falling interest rate environments.
The conversion feature is provided by almost all bank originators of HELOCs today. Increasingly it entirely replaces the traditional fixed rate home equity loan product, which has wilted under regulatory pressure, including: 1) new rules and regulations stemming from Dodd-Frank legislation; and 2) the integration of the Real Estate Settlement Procedures Act (RESPA) and the Truth in Lending Act (TILA) by the Consumer Financial Protection Bureau (CFPB).
It is easy for HELOC borrowers to exercise the fixed rate option and implementation costs are low. Locking in a fixed rate on a portion of an outstanding balance can be a simple as making a phone call and requesting the desired draw and repayment term. No additional underwriting is necessary, and often the process is completed within the day. Typical restrictions include minimum loan amounts, maximum terms (i.e., the remaining maturity date on the HELOC), and limits on the total number of fixed rate options that can be exercised at one time.
While FROs are great for borrowers (and marketing teams), finance managers can take it on the chin, depending on pricing. Variable rate products are a bank’s best friend, effectively transferring interest rate risk from the balance sheet to the borrower. The fixed rate option enables the borrower to give back the rate risk. Conversions commonly occur only when rates rise, when it is in the best interest of the borrower.
If banks price the FRO too low, they are left with below-market returns and extension risk from slowing repayment when market rates are rising. If pricing is too high, balances will be lost as customers refinance debt with competing institutions.
On the flip side when rates are falling, repayment of fixed rate balances can soar. Aggravating the situation, any remaining floating rate HELOC borrowing capacity can be tapped at successively lower cost to retire fixed rate balances booked at prior higher rates.
While most HELOC balances have been carried at variable rates in recent years, the picture could change if market interest rates rise strongly enough to catch widespread customer attention. Based on behaviors seen in the last rate cycle (pre-recession), roughly a fourth of accountholders eventually may consider locking in rates on a least a portion of their balances. The traditional fixed rate home equity loan is declining under the weight of new regulation, meanwhile, shifting further prominence to fixed rate options.
Given this dynamic and the maturity of the fixed rate option as a product feature in the industry, surely banks have developed appropriate pricing, fees, policies and guidelines to assure that balance sheets are protected. But have they?
A quick look at industry FRO rates displays anything but an efficient market (Figure 1: Pricing Dispersion with Fixed rate Options). In our study of select markets, the severity of dispersion from the average suggests that lenders are pricing more on the basis of random internal influences, as opposed to systematic execution of strategy.
Lines of Defense
To protect financial returns on the home equity line of credit, FRO pricing must accurately reflect the risk consequences when a variable-rate HELOC balance is flipped into a fixed rate loan. Pricing should also support the bank’s goals in balance formation vs. margin enhancement, as informed by price elasticity of demand.
As with our study of absolute FRO rates in select markets, a companion review of FRO premiums (i.e., the incremental increase from the prevailing variable rate when a balance is converted to fixed rate) shows a wide dispersion (Figure 2: Fixed rate Premiums vs. HELOC Variable Rates). It is hard to see how internal managers could defend current practices.
A case in point is the practice of adjusting rates to recoup origination costs. This is a common strategy seen throughout home equity lending, however it is half-baked when incorporated into FRO pricing decisions. Granted, if a new borrower is signed up with no origination fee and immediately takes a fixed rate draw, then origination expenses should be factored into the rate.
The catch is that much of the new FRO production sparked by rising rates will be a transfer of balances already on the books. Pricing out origination expense for a second time may not be ideal or necessary. Consider a HELOC borrower of five years’ standing, now fearful of rising rates and ready to pull the trigger on a FRO. Is origination expense still part of the pricing equation at this point? Add in the fact that if pricing is significantly higher than competitors (some of which are likely offering a no-fee refinance), the balance is now at risk of attrition.
This gets to product design and fee strategy. One workaround is to link origination expense recapture to FRO conversions occurring only within the first year of the account relationship. This window preserves initial expense recapture without undercutting the retention value of load-free rates later in the borrowing relationship. For banks determined to preserve a fee-free product, a viable alternative is to manage a second rate sheet tied to fixed rate options in the first year.
Product policies and guidelines also need review, for example in the treatment of small balances. At the onset of the account, banks would want to avoid no-fee origination of fixed rate balances. Much later in the relationship, conversely, offering the fixed rate option on small balances may be ideal for retention, given that origination expenses are already sunk at this point.
Lenders should also review fee options on fixed rate balance conversions as the industry enters a rising rate environment. Competitively, there may be marketing advantages in offering lower FRO rates supported by transaction fees (which likely would be well-tolerated by customers wanting to avoid rate exposure).
While competitive pricing may appear idiosyncratic, it should not be ignored. With most current HELOC offers remaining “fee free,” borrowers encounter little friction in switching lenders to refinance debt. And with lenders increasingly relying on the fixed rate option as a replacement for the traditional home equity loan, FRO rates represent the entry point for a potential refinance. In formulating pricing strategy, bankers should ensure they have captured the correct “consideration set” of alternative competitive offers that borrowers may be considering in a given setting.
It also important to adjust pricing strategy for varying local market conditions. As we have observed with other banking lines of business over the years, HELOC pricing can vary significantly from one geographic market to the next. Yet the typical lender response falls short, either through inflexible standard prices system-wide or over-reliance on the scattered practices of regional management.
The process of managing an FRO rate sheet should also be evaluated, given the volatility seen at the longer end of the yield curve recently. Large sell-offs in the bond market could create a situation where fixed rate assets are locked in at below-market returns. We recommend monitoring similar duration interest rate swaps as a market proxy, then setting a strict threshold on any market movement to update pricing.
Zach Wise is a Principal and Ryan Ritz is a Managing Director in the Charlotte, N.C. office of Novantas Inc., and Lee Kyriacou is a Managing Director in the New York office. They can be reached at firstname.lastname@example.org; email@example.com; and firstname.lastname@example.org.