Warnings Raised on Home-Equity Loans : Some Planners Say New Form of Credit Offered by Lenders Could Bring Risks

Lenders are rushing new home-equity line-of-credit programs to market in the wake of tax reform, but financial planners and other experts are waving a caution flag to warn homeowners who are thinking about tapping the equity in their house for extra cash.

“If you go out and buy some furniture and then stop paying your bills, the company can come and take your couch,” says John Cahill, a partner in the financial planning firm of Carroll/Cahill Associates in San Francisco. “But if you don’t make your payments on a home-equity loan, the lender can take your house.”

Adds Lawrence Krause, another San Francisco financial planner, “If you’re going to borrow money, you should have a reason--don’t borrow just because you have some equity in your house. Have543236208money.”

Homeowners across the country began being inundated with advertisements and direct-mail pieces from lenders anxious to give them a line of credit based on the equity they have in their home a few months ago.

Open-Ended Accounts

The media blitz was triggered when Congress decided to retain tax deductions for mortgage-related interest payments, but phase out deductions for interest payments on “consumer loans” for objects such as cars, boats, clothes and furniture.

Unlike a “pure” home-equity loan--which typically gives the borrower a lump sum of cash and is repaid at a specified amount each month over a specified length of time--most home-equity credit lines are open-ended accounts that allow the owner to convert their equity into cash simply by writing a check or using a credit card.

In effect, the accounts can allow homeowners to continue writing off interest payments for consumer goods because the loan is secured by real estate.

These credit lines are the financial “product of the 1990s,” says Jerry Weeks, senior vice president of real estate operations at Beverly Hills-based Great Western Savings.

Advertising Paying Off

He notes that such programs can allow equity-rich homeowners to use the value of their homes to finance purchases ranging from a once-in-a-lifetime vacation to a child’s education--and still deduct at least part of the interest expense at tax time.

Lenders’ expensive advertising campaigns are already paying off handsomely. When Home Federal Savings & Loan Assn. recently sent out some 175,000 direct-mail letters about their home-equity credit lines, more than 7,000 homeowners had responded only three days after the first mailing went out. “That was triple our projections,” says Dennis Casey, a Home Fed vice president.

But it’s that kind of amazing response that has some financial planners concerned. Their biggest fear is that homeowners, lured by the credit lines’ huge limit and easy access, may borrow money needlessly and have trouble paying it back later. In extreme cases, they say, such borrowers will lose their house because they’ve pledged it as collateral for their credit line.

‘Playing Russian Roulette’

“You’re playing Russian roulette with your house,” Krause says. Since rates on most home-equity loans are adjusted monthly, he explains, “you’re borrowing money and you don’t know what your interest rate will be a year from now, or 10 years from now. And I think there’s a real possibility rates could be a lot higher.”

What type of homeowners are most likely to get in over their heads? Krause says it’s probably people in their 30s or 40s who are already used to borrowing heavily. But others say it could be older people who have homes that are virtually paid off; if they dip too far into the equity in their home, they may have problems paying the loan back because their income could drop sharply after retirement.

Lenders, however, doubt there will be many foreclosures.

“There’s not going to be a whole lot of people who will let us put a lien on their home without really understanding what they’re getting into,” says Casey at Home Fed.

Safeguard Against Defaults

Weeks at Great Western notes that the home-equity accounts his institution opens will be serviced by the company’s credit-card operation instead of its real estate loan department.

He figures that should help safeguard against defaults because credit-card servicers are good at spotting and correcting a person’s credit problems before they get out of hand.

“People shouldn’t take out a home-equity loan simply for tax deductions,” says Weeks. “It has to make good economic sense.”

Financial planners agree that the accounts shouldn’t be set up merely for tax purposes. But they generally reject lenders’ claims that people should pledge their home as collateral for a loan to buy a boat or vacation in Tahiti.

Other Funding Sources

Instead, they say home-equity lines of credit should only be used to meet major, mandatory cash outlays and, unfortunately, they usually aren’t the type of expenses people like to incur. Among those are meeting a child’s college expenses, paying for expensive medical treatment or starting a business.

Even then, they caution, the homeowner may be able to obtain cheaper financing by having the child take out a government-backed student loan, borrowing against an existing annuity or life insurance policy or by seeing if government-related programs will ease the financial burden of big medical bills or starting up a business.

“You’ve got to find out where the cheapest sources of financing are first,” Krause says. “Your home is one of the last things you want to use as a source of cash.”

But the home-equity loans may be particularly attractive to people who already have a lot of high-interest debt from credit-card charges or auto or personal loans, according to Philip Kavesh, a tax manager and personal financial counselor in the Los Angeles office of the Laventhol and Horwath, accountants.

Retain Some Deductions

“A lot of people are paying 21% interest on their credit cards or have older auto loans at 15%,” Kavesh says. Since most home-equity loans currently carry interest rates in the 9%-range, he says, “you might get quite a good break on interest rates” by taking out a loan on your house and using the proceeds to pay off the loans with higher interest rates.

Kavesh says an added bonus is that such a borrower will be able to retain at least some of his deductions for interest payments because the debt would now be linked to his mortgage.

However, he notes, the new tax law will limit those mortgage-interest deductions to the original cost of the home, plus the cost of any improvements you’ve made since you lived there. Deductions for a loan of more than that amount will be phased out over four years, unless you use the money to pay medical bills or certain educational expenses.

For example, suppose you bought your home 20 years ago for $30,000 and have since added a bedroom for $10,000. Prices have been rising, and now your house is worth $160,000.

If you open a home-equity account with a credit line of $60,000 and use it to buy a boat, you’ll only be able to fully write off interest payments on $40,000 of the loan.

Effects of New Code

Only 65% of the interest payments on the remaining $20,000 can be written off next year; 40% in 1988, 20% in 1989, and only 10% in 1990. By 1991, the new code will prevent you from writing off any of your interest payments on the $20,000.

Some lenders have been criticized for using the new tax legislation as a theme in their recent marketing efforts and then failing to fully explain the effects the new code will have on the accounts when a homeowner is ready to sign the loan papers.

Meanwhile, lenders’ market battle for new home-equtiy accounts promises to get even more intense over the next few months, as more bankers enter the fray and the Jan. 1 tax changes draw nearer.