Tax Code Changes Spur New Strategies to Cope : Home-Equity Loans Could Become Future Consumer Credit Base

Dick O’Melveny is sick and tired of paying high interest rates on credit cards and auto loans. But the Rancho Palos Verdes computer executive, like thousands of other Americans, thinks he has found a cure: a home-equity loan.

O’Melveny plans to use money from such a loan to pay off his credit card bills, which now cost him more than 18% in interest, and his auto loan, which costs him 17%. By contrast, some home-equity loans now charge interest of as little as 8.5%. And under tax revision, the interest on home-equity loans may be deductible, while interest on most other consumer debt will not be.

And, because the loan--actually a line of credit--can be continually tapped, he can use it in the future to buy cars or other items without having to take out new loans. “The paper work at banks is terrible,” he said. “This is a good way of getting around that.”

Seen as a convenient, cheaper way to pay for cars or other expenses while still deducting interest payments under the new tax law, home-equity loans are becoming one of the nation’s fastest-growing financial products.

Banks, savings and loan associations, brokerage firms and finance companies nationwide are aggressively touting the loans as convenient devices to pay off credit card loans, buy autos or other expensive items, make home improvements or pay children’s college education. Competition is heating up so much in some markets that institutions are waiving fees or cutting initial interest rates to as low as 2.9%.

Some financial experts say that the convenience of home-equity loans could transform and expand consumers’ use of credit. The ability to buy cars or pay college expenses out of a single loan reduces the hassle of reapplying over and over again for separate loans. And the longer maturities of such loans, compared to such shorter-term loans as auto loans, could allow Americans to take on even more debt, because monthly payments on longer-maturity loans are generally lower.

Tied to Credit Cards

Also, a growing number of financial institutions are expected to offer credit cards tied to home-equity loans, giving borrowers all the conveniences of credit cards but with much higher borrowing limits and lower interest rates.

“It’s growing like crazy,” Wayne F. Bengtson, program director for consumer lending at the U.S. League of Savings Institutions, said of the home-equity loan boom. About 65% to 70% of the nation’s 3,400 savings and loan firms now offer some type of home-equity or second-mortgage loan, double the percentage of a year ago, Bengtson estimated.

“The home-equity loan will be the darling of 1987 for the banking industry,” predicted Robert Heady, publisher of Bank Rate Monitor, a North Palm Beach, Fla., newsletter. “By the end of next year, every major bank and thrift in the country is going to be marketing home-equity loans.”

But not everyone is cheering the home-equity boom. Consumer advocates and advisers express growing concern that some consumers--already overextended with mortgages, credit cards, auto loans and other debts--might borrow more than they can handle.

Could Lose Their Homes

Experts also are concerned that consumers may not know the full costs and risks of such loans. The fees and other costs may outweigh the tax benefits, they say. And failing to make payments could result in consumers’ losing their homes.

“We think, in general, that they are a bad idea,” said Alan Fox, a legislative liaison with the Consumer Federation of America, a Washington-based consumer group that is calling for congressional hearings on home-equity loans. “If you are going to borrow, there are better ways that don’t have the risks that home-equity loans have.”

Casualties of Mad Rush

Some experts also are afraid that, in a mad rush to seek borrowers, some lenders are not adequately informing customers about closing costs, annual fees and rates.

“There’s going to be such a mad competitive scramble . . . that some of these institutions might fail to properly counsel homeowners and show them what can happen and what they can afford,” Bengtson of the U.S. League of Savings Institutions said.

Second-Mortgage Alternative

Banks and other institutions began offering home-equity loans about five years ago as a more flexible alternative to the traditional second mortgage. The second mortgage requires consumers to borrow a fixed amount, using home equity as collateral. Consumers must pay back second mortgages in fixed, equal monthly payments of principal and interest over a set period of time, usually between 15 and 30 years, similar to first mortgages.

However, home-equity loans are structured more like credit-card loans. They give the borrower access to a line of credit, sometimes as much as $100,000 or more, secured by home equity. The borrower may borrow as much or as little as he wants, gaining access to the money through checks or, in some cases, through credit cards.

The borrower also is not locked into fixed monthly payments. Instead, he may repay as much or as little as he desires, although most lenders require a minimum monthly payment of interest only. Most home-equity loans carry variable rates, whereas second mortgages often come with fixed or variable rates.

Two Years’ Momentum

Home-equity loans began gaining popularity about two years ago as consumers sought ways to tap into their home equity to make other investments and to reduce their borrowing costs from the high interest rates charged on credit cards or unsecured personal loans.

Interest rates on credit cards and unsecured personal loans can run as high as 20%, while most home-equity loans now carry rates of between 8.5% and 10%. Institutions can charge lower rates on these loans because they are secured by borrowers’ homes and are thus less risky to the lender than unsecured loans, Roger Schwarz, a Los Angeles financial adviser, said.

“If we want to make a big purchase, we don’t have to take it out of savings,” a New York musician said about the benefits of a home-equity loan she and her husband took out recently. They will pay 9% interest on the loan, considerably less than the 13.5% they were paying on an auto loan, she said.

But the latest and perhaps biggest boost to home-equity loans is coming from President Reagan’s signing in October of the Tax Reform Act of 1986. The act phases out, over four years, deductions for interest on such non-mortgage consumer borrowings as auto loans and credit-card loans. Next year, only 65% of the interest on these non-mortgage loans will be deductible. That falls to 40% in 1988, 20% in 1989, 10% in 1990 and none thereafter.

Deductions Preserved

However, deductions for interest on mortgage loans--such as home-equity loans--are preserved under tax revision. Taxpayers may deduct interest on loans up to the original purchase price of the home, plus the cost of any improvements. (Interest on mortgages beyond that is deductible only if the loans are used for further home improvements, or medical and educational expenses.)

Overall, home-equity loans on the books of the nation’s banks, savings and loans, finance companies and others will grow to about $40 billion as of year-end, up from virtually nothing three years ago, according to SMR Research Corp., a New Jersey financial services research firm surveying home-equity loans. Those loans and second mortgages will together account for about $200 billion in loans outstanding nationwide as of year-end, SMR estimated.

“It’s the product of the future,” SMR President Stuart Feldstein said, predicting that the amount of home-equity loans outstanding will more than double by the end of this decade.

Impressive Potential

Indeed, the upward potential for growth in the home-equity loan field is impressive. Americans hold more than $3 trillion in untapped equity in their homes, some financial experts estimate. A survey in August by Synergistics Research Corp., a financial services research firm in Atlanta, contends that only 13% of homeowners with incomes of at least $25,000 now have a home-equity loan, but that 39% of those homeowners express some interest in such loans.

“A majority of Americans still don’t know what this product is,” said Robert Pierson, vice chairman of Carteret Savings Bank of Morristown, N.J., an aggressive marketer of home-equity loans. “We’ll be making inroads as more and more institutions advertise. That means more business for all of us.”

To gain market share, a number of institutions, particularly in the Southeast and Northeast, are slashing introductory “teaser” rates to apply to the first few months of the loan. One institution, First Florida Bank in Tampa, has been offering a 2.9% initial rate.

Other institutions are waiving origination fees and closing costs, which can run as high as $2,000 or higher. Los Angeles-based California Federal Savings, for example, has waived its normal $400 origination fee for loans applied for through Dec. 31. One result: applications for home-equity loans at Cal Fed were up 175% in October and November over July and August, said E. John Doyle, the firm’s senior vice president for consumer financial services.

Inquiries Double

Wells Fargo Bank of San Francisco, one of the nation’s largest home-equity lenders, is waiving its $450 home-equity loan fee through year-end, and inquiries have doubled, spokeswoman Lisa Worthington said.

At Home Federal Savings, based in San Diego, response to a recent direct-mail campaign sent to 350,000 households is “four times greater than expected,” said Dennis Casey, vice president and group product manager for retail loan services.

San Diego-based Imperial Savings is one of several institutions allowing borrowers to gain access to their home-equity loans through credit cards. Auto clubs, labor unions and other membership groups may soon offer their own home-equity loans to members through tie-ins with financial institutions, Feldstein of SMR Research predicted.

Are Risks Understood?

But, amid the frenzy, the fears of some financial advisers persist that consumers are jumping on the home-equity bandwagon without realizing the risks and costs.

Paramount is the risk that a consumer may lose his home if he cannot make payments. “If you fail to make payments on a credit card you may end up with a poor credit rating or in personal bankruptcy, but you won’t lose your home,” said Gail K. Hillebrand, staff attorney in the San Francisco office of Consumers Union, publisher of Consumer Reports magazine. “With a home-equity loan, you’re really upping the stakes.”

“Home-equity loans may not be the panacea for all borrowers, especially when you are jeopardizing the equity in your home,” said Richard C. Peterson, first vice president for the Southern California division at Glendale Federal Savings, which is not pushing home-equity loans aggressively. “People have to look at their financial situation and see what they’re willing to sacrifice.”

Some advisers also are concerned that the great flexibility of home-equity loans could undo some undisciplined consumers who borrow beyond their means. The temptation to over-borrow could be enhanced if credit cards are tied to the home-equity loans, some advisers fear.

‘Frivolous Purchases’

“There is a danger of consumers making frivolous purchases when they all of sudden have $40,000 or $50,000 behind their credit card,” newsletter publisher Heady said.

Also, most home-equity loans have terms of between five and 10 years. At the end of those terms, borrowers often are required to make a lump-sum “balloon” payment of the remaining unpaid balance.

“That heightens problems for those who are not self-disciplined and can’t make the lump-sum payment,” Fox of the Consumer Federation of America said, adding that the fixed monthly payments of traditional second mortgages might be safer for undisciplined borrowers.

Another drawback is that some lenders periodically review borrowers’ credit-worthiness, said Ronald W. Kaiser, a director of Bailard, Biehl & Kaiser, a financial planning firm in San Mateo. A borrower deemed not credit-worthy could have the credit line withdrawn, at which point the outstanding balance would become due either immediately or over a set period, he said. “You don’t know for sure if the loan commitment will be there if you need it,” he said.

‘Inactivity Fee’ Possible

Also, borrowers not using their line of credit within 12 months might be charged an “inactivity fee” that could run as high as $300 a year, Heady warned.

Financial advisers also suggest that the fees on home-equity loans could outweigh the tax advantages of deducting the interest. Many home-equity lenders base fees on a percentage, often 2% but sometimes higher, of the total amount of the credit line. But if a consumer only borrows a fraction of that total credit line, the cost as a percentage of the amount borrowed would be far higher.

Advisers also are concerned that some homeowners may take out home-equity loans hoping to deduct all the interest for tax purposes, only to realize later that some of that interest is not deductible. That could happen if the homeowner borrows more than the original purchase price of the home, plus the cost of improvements.

One of the biggest risks is the possibility that interest rates could go far higher than initially anticipated. Home-equity loans generally carry variable rates pegged at between 1 and 3 percentage points above the banking industry’s so-called prime rate or certain certificates of deposit or Treasury bill rates. But, unlike most first or second mortgages, variable rates on home-equity loans generally carry no upward limits, or “caps.”

Doubled Interest Costs

Thus, a return to the days of the late 1970s and early 1980s, when the prime rate topped 20%, could double interest costs. Consumer Reports magazine calls loans with uncapped variable rates “a form of financial Russian roulette to be avoided.”

Experts also fear that the rush to home-equity loans could lead to the wider entrance into this market of unscrupulous second-mortgage lenders and brokers, who have preyed on less sophisticated or less credit-worthy lower-income or elderly consumers in recent years. Although these operators represent only a small fraction of the total second-mortgage market, thousands of consumers have lost their homes through foreclosures on questionable second mortgages.

Some of these second-mortgage loan brokers charged exorbitant fees as high as 30% of the loan, or interest rates as high as 25%. One, Landbank Equity Corp. of Virginia Beach, Va., which collapsed into bankruptcy proceedings in 1985, charged fees as high as 40% of the loan amount, said Kathleen Keest, an attorney with the National Consumer Law Center in Boston.

Some of these brokers made loans knowing that the borrowers would be unable to fully repay. Or they forced borrowers to take loans for amounts far higher than the borrower wanted or could afford to repay. These brokers would collect the loan fees, then would often sell the loans to investors who were left holding the bag if the loans soured.

Waiting for Entrants

“I’m waiting for the people making money off second mortgages to decide how they are going to tap into home-equity loans,” said Ann Haskins, associate director of Public Counsel, a public interest law organization in Los Angeles that has handled or referred dozens of cases involving questionable home-loan practices. As an example of such practices, Haskins cited a case of a Valencia nurse who sought a $10,000 loan to repay other debts but instead was suckered into taking a $30,000 loan, which she could not repay.

Such cases of abuse have subsided in recent years, at least in California, partly because lower interest rates have made it easier for borrowers to qualify and make payments, contended James Edmonds Jr., commissioner of the California Department of Real Estate, which regulates mortgage brokers and lenders. Also, more reputable lenders such as major banks and savings and loan firms have entered the business, increasing competition and driving down fees and rates, Edmonds said.

May Generate Regulation

However, there will always be borrowers “whose credit is so bad” that they are vulnerable to unsavory lenders, Edmonds cautioned. They will be even more vulnerable if interest rates surge upward, he added.

These pitfalls could lead to more regulation of the home-equity field, or at least could cause lenders themselves to offer greater safeguards, some advisers and banking officials predict.

For example, competition might force more lenders to offer caps on the variable rates on home-equity loans, similar to the caps on adjustable-rate first mortgages, Bengtson of the U.S. League of Savings Institutions said.

“Consumers will demand it,” he said.