Contract for home-equity loan must disclose lender's option to cut off credit


WASHINGTON -- The Federal Reserve Board has issued a key ruling affecting thousands of current and future home-equity-loan borrowers.

After six months of debate, the board voted recently to tighten certain disclosure requirements for home-equity lenders.

The Fed said lenders must now state in the equity-line contract document that they retain the option to cut off credit advances whenever the rate cap is reached.

Existing federal regulations do not mandate such a disclosure.

Though the new rules represent an effort by the Fed to provide stronger protections to home-equity borrowers, they also signify a setback for Consumers Union.

In a suit filed last November, Consumers Union challenged the Federal Reserve Board's legal authority to permit any freezes of credit-line drawdowns because of rate caps.

The Fed strongly disagreed.

The suit was dismissed by the U.S. District Court for the District of Columbia last May but is under appeal.

At the core of the equity-line freeze issue are two competing needs: the homeowner's desire for credit under predictable and acceptable terms and the lender's desire to lend money at a profit.

Most home-equity lines of credit are adjustable-rate second mortgages secured by principal residences. The contractual terms typically provide for a basic rate index, such as the bank prime lending rate.

On top of that is a rate margin -- a fixed charge that is added to the index every month or periodic adjustment date.

The rate on the credit line commonly has annual and lifetime caps or maximums.

During the course of a year, for instance, your rate might be limited to an increase of no more than 1 or 2 percentage points. The same loan may include a lifetime maximum of, say, 13, 15 or 18 percent -- the top rate you'll ever be charged.

Borrowers can draw down funds on their equity line until they reach a predetermined limit, or enter the principal payback period for the loan.

When the Fed first issued regulationsimplementing the Home Equity Loan Consumer Protection Act in June 1989, itexpressly permitted lenders to halt draw

downs on lines of credit when rate caps were hit.

Say you have a $50,000 home-equity line with a 15 percent lifetime rate cap. You've already drawn down $10,000. Say also that because of an international economic crisis, the prime rate zooms to 16 percent. You have a need for another $20,000 and you'd like to tap your equity line at its maximum rate of 15 percent. The bank, however, says no dice. With a prevailing market (index) rate higher than your maximum cap rate, says your lender, we can't -- or won't -- give you a cent until rates come down.

Consumers Union argues that lenders shouldn't be allowed to turn off the spigot like that, even if the right to do so is clearly disclosed to borrowers in advance.

The Fed argues the reverse: To force lenders to lend money on uneconomic terms opens a Pandora's box for consumer and lender alike.

Prohibiting credit-line freezes when rates exceed the cap, the Fed said in a discussion of its new rule, ultimately would cost borrowers more. Banks simply would raise the lifetime caps in all new home-equity lines of credit to much steeper levels -- 18 to 24 percent, for example, rather than 15 percent or lower.

Or they would shorten the term of the drawdown period, increase the margin, tighten credit standards or get out of the home-equity-line business altogether, thereby reducing the benefits of competition.

If borrowers want to ensure their ability to continue drawdowns zTC beyond the lifetime rate-cap limit, said a Federal Reserve staff analysis accompanying the new regulations, they can readily "negotiate a higher rate cap from the lender before entering into [the line-of-credit agreement]."

The key to the issue, said the staff memo, is that rate caps and drawdown freezes be genuinely "bilateral," agreed to and understood in advance by borrower and lender.

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