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Rethinking the Home Equity Line of Credit

It is time for banks to reconsider home equity growth strategies. There are substantial opportunities in targeting and offer design, including the use of precision pricing.

Home equity lenders refocused their marketing and underwriting approach in the wake of the 2008 credit melt-down, but have they now fenced themselves in?

In walling off risk exposure, most banks have raised thresholds on FICO scores; lowered combined loan-to-value ceilings; and tightly focused on cross-sell to established deposit customers. While understandable as a crisis response, such tightening is now inadvertently compromising balance growth and profitability in a recovering market.

The irony of focusing on the most creditworthy borrowers is that by virtue of their overall solid finances, these customers are the least likely to use their home equity lines of credit. Meanwhile, substantial opportunities are being overlooked among broader categories of potential home equity borrowers, both in terms of targeted customer acquisition and needs-aligned offers, including the use of precision pricing to encourage profitable usage.

To unlock expanded opportunities and uphold risk-adjusted returns, banks will need a stronger collaboration among the functional support teams involved in developing the offer and eligibility criteria, namely: credit risk, product, and distribution management. The goal is to identify creditworthy pockets of opportunity in the overall market and current customer base; design offers to enhance marketability and encourage profitable usage; and effectively deploy offers, not only through the branch, but also via mail, online and through the contact center.

One strong advantage that banks have in this quest is access to extensive customer information, including transaction flows and comprehensive financial and household profiles. Distilled in the right way, this information provides far more insight than a simple FICO score, permitting a more nuanced and effective customer sales and activation strategy.

Crisis Response

For many bank-owned lenders today, home equity credit risk management still centers on avoiding delinquencies and losses. The situation traces back to the explosion (and misuse) of the home equity line of credit.

In the years leading up to the housing meltdown, HELOCs were often used as a concurrent “piggy-back” to a first mortgage, permitting borrowers to avoid requirements for private mortgage insurance on loans exceeding 80% of property value. These piggy-backs also helped borrowers to avoid a jumbo loan designation, thus escaping a 25 to 75 basis-point rate hike applied to loan balances that exceed GSE loan size limits.

Combined with looser first mortgage underwriting qualifications, aggressive appraisal valuations and copious third-party originations, these practices ballooned originated HEL commitments to nearly half a trillion dollars in 2008. Following the credit melt-down that decimated U.S. employment, home equity loan portfolios generated massive losses and collateral protection evaporated for most high loan-to-value, second lien HELOCs.

With portfolio performance in such bad repair following the recession, virtually every bank lender revamped its approach to HELOC lending. Credit eligibility criteria were dramatically tightened (through higher FICOs, lower LTVs, and increasingly through tenured deposit relationships). Meanwhile plummeting home values and rising unemployment greatly narrowed the eligible customer base. Outstanding balances were further constrained as banks almost exclusively focused on top-tier customers, most of whom had long tenured relationships, stable deposits and excellent credit scores — but often the least need for credit.

Today, significant opportunities are being overlooked with a broader category of eligible borrowers in under-targeted customer segments. These prospects are creditworthy and more likely to borrow, yet many banks have yet to follow through by providing better-aligned offers that meet their most salient needs. We have also discovered many lenders using aggressive pricing as the only key offer feature, regardless of a customer’s specific needs or preferences.

Risk, Products, Distribution

To make perfectly clear, this situation by no means constitutes a call for renewed exposure at the shaky end of the home equity lending market. However, it does make a case for reexamination of current lending strategies, capabilities and management practices. At many banks, home equity originations continue to be held back by conflicting organization objectives and skill handicaps. For example:

Credit risk. These teams have been through a lot, but the goal of managing risk-adjusted returns has morphed into avoiding virtually all losses, which inadvertently misses large pockets of profitable lending opportunities. The typical bank is no longer incurring loan losses in home equity, but not really growing outstanding balances and profits either.

Product management. Home equity growth and profitability appeared to take care of themselves in the high-volume atmosphere prior to the recession, but it seems abundantly clear that sustainable and profitable growth will require a more refined approach. Yet at many banks, the product management teams still lack the advanced analytics needed to properly align offers with a customer’s most salient borrowing needs. Pricing is perhaps the most visible offer feature and needs to be precisely developed and deployed at a more discrete level, balancing the dual goals of fostering both growth and risk-adjusted returns.

Distribution management. Success in targeted customer acquisition and segment-based product development and pricing ultimately hinges on the distribution system. But at many banks, distribution teams have a limited ability to deliver segment-tuned offers quickly and dynamically through the branches. More work is also needed to effectively coordinate and leverage alternative channels — especially important given that a growing number of customers are not visiting the branches.

Leveraging Customer Knowledge

For many organizations, there are three areas for immediate focus in reenergizing home equity lending: targeting, offer design and pricing. With core customers, banks can harness deep, transactional customer information to develop a nuanced understanding of potential profitability and preferences, valuable for both targeting and offer management. Banks are also well positioned to calibrate pricing tradeoffs based on their superior knowledge of established customers and how they behave.

Across these three areas, the product management, credit risk, and distribution groups should be working in concert to deliver the right offer to the right customer, through the channel each prospect prefers. The results manifest themselves across three tangible areas of home equity origination:

1) Improved targeting helps the bank to identify prospects who are more likely to both respond and use the HELOC. As an example, this might include prospects with slightly-lower FICO ranges and more volatility in their primary deposit account balances, yet with deep, tenured bank relationships that often translate into lower expected loss profiles. This contrasts with a silo-based credit risk management objective of incurring no losses, which inevitably misses big pockets of profitable borrowers.

We have discovered key customer relationship markers that can drastically lower delinquencies within a given FICO tier (Figure 1). These same characteristics are linked to higher levels of product usage as well. In combination, these factors create a much more attractive profile of risk-adjusted profitability for a lender.

2) Needs alignment — households have important credit needs for specific purposes such as remodeling, financing college tuition and handling major contingencies, and HELOC products are best designed and marketed within this context.

Customer needs can be clarified in several ways: during live assessment of borrowing needs, or by deploying advanced analytics based on a customer’s transactional data (both credit and deposits), or through ongoing customer and market research. A more comprehensive approach to customer relationship management has greatly enriched banks’ understanding of the customer base, allowing for more intelligent offer design and dissemination.

3) Precision pricing can also accelerate growth while preserving (or even enhancing) margins. Often today we find a significant portion of originated accounts inadvertently priced “underwater” from a risk-adjusted return perspective.

By contrast, advanced pricing approaches integrate a customer’s prospective profitability; competitive market considerations; and the customer’s behavioral profile, including relative sensitivity to rates (vs. other offer features such as fees, minimum payment and rewards). Such analytics provide nuanced segment insights into customer behaviors and provide a sound basis for testing new offer strategies.

Banking executives have no time to waste in coordinating efforts to accelerate profitable home equity growth. With home prices stabilizing, most refinances completed at historically low rates, and consumer credit profiles on the mend, many institutions will need to quickly morph their current strategies to take advantage of this opportunity.

Kenneth Alverson is a Managing Director and Grace Lee is a Manager at Novantas Inc., a management consultancy based in New York City. They can be reached at kalverson@novantas.com and glee@novantas.com.

For more information, contact Novantas Marketing

+1 (212) 953-4444