YOUR TAXES : PART TWO: REAL ESTATE : Home equity loans enjoying a rebirth : Once a lending ‘black sheep,’ writeoffs, lower rates spark new interest

Suddenly the home equity loan, for 55 years the loan of last resort for Americans in financial straits, is the hottest financial product in town.

“It’s one of the most amazing turnarounds I’ve ever seen. Ever since the Great Depression, this was the black sheep of the lending industry . . . and all of a sudden black wool is in,” said Stuart A. Feldstein, president of SMR Research, a New Jersey researcher and publisher that just completed a yearlong study of home equity lending.

The catalyst? To a large degree, tax reform.

Under the vastly altered tax laws, interest charges on loans secured by homes are still fully tax-deductible in most cases. No other consumer interest is.

So consumers, their appetites whetted by a massive advertising blitz, are flocking to banks, savings and loans, consumer finance companies and other financial services firms to trade in their car loans and other consumer debt for a loan secured by the equity in their homes.

Once there, they discover that tax-deductibility isn’t the only advantage of home equity loans--or HELs, as the financial industry has dubbed them. The interest rates are much lower than on other consumer loans, and the payoff period is at least three times as long.

Together, that means much lower monthly payments for consumers in need of extra cash or a tax writeoff. It is also a boon to lenders, some of whom have watched their home equity business more than quadruple in less than six months.

So why do lenders such as Robert Weber, vice president of product management for Security Pacific National Bank, consider these loans “a frivolous way of using something that’s very dear” to homeowners?

“Many consumers don’t think it makes sense to take a home, an appreciating asset, and use that to pay for a depreciating asset such as a car,” said Weber.

The flexible interest rates that most of these loans carry is another concern. Rates are low now. But if they start rising, debt counselors fear, many home equity borrowers may find themselves overextended.

“There is a great temptation here to over-borrow,” Feldstein said.

The concern he shares with many debt counselors and lenders is this: Joe Consumer visits his local banker, intending to take out a $5,000 home equity loan so he can pay off his car loan and some hefty Christmas bills. Instead, he walks out with a $20,000 line of credit, secured by the equity in his home, after learning that he pays no more to get four times the borrowing power.

“There’s no danger as long as his financial situation doesn’t sour and this environment of low interest rates continues,” Feldstein said.

So what do you do? Tax reform, bill consolidation or a sudden thirst for some expensive new possession has you pondering the wisdom of using your home as security for a loan. Lenders of all sizes and persuasions are inundating you with sales pitches for home equity loans, each slightly different. But you still remember when second mortgages were something to be embarrassed about--a black mark against your financial prowess.

After investigating these loans for a full year, Feldstein concludes that the home equity loan “is absolutely a good deal.”

But he urges that each consumer decide for himself--by drawing up a list of pros and cons.

The tax break driving the current rush into home equity loans is a good place to start.

Among the popular breaks that lawmakers have excised from the tax code is the deduction for consumer interest charges. In the past, taxpayers who itemized their deductions could subtract from their gross income any interest they paid on credit card bills or on consumer loans for cars, furniture, college tuition and the like.

Beginning this year, that deduction is gradually being phased out. Such interest will be 35% disallowed in 1987, 60% disallowed in 1988, 80% disallowed in 1989, 90% disallowed in 1990 and eliminated in 1991.

As is often the case when a popular tax break is under siege, though, inventive accountants searched for and quickly found a loophole in the new tax laws.

The upshot: Homeowners who itemize their deductions still have a way to deduct such interest.

The strategy: Take out a second mortgage on your house, secured by the equity you have built up in it, and use the money to pay off your car loans and other consumer debts.

Your overall debt and the interest payments you make on it may not change at all. But your out-of-pocket expense will decline using this strategy because the interest on home equity loans remains deductible under tax reform--as does the interest on first mortgages on a homeowner’s primary residence and second home.

Lawmakers did write in some limitations. Interest on such loans is tax-deductible only if the sum of all loans you have on your home doesn’t exceed the home’s original purchase price plus the cost of improvements.

Say you paid $150,000 for your home, spent $25,000 fixing it up and have paid your first mortgage on the house down to $100,000. Under the new tax law, you could deduct your interest expenses on a home equity loan secured by this house as long as the loan isn’t bigger than $75,000.

If you are borrowing the money for educational or medical expenses instead of to consolidate loans or buy something new, the home’s original purchase price isn’t a limitation. The only restriction in these cases is that the sum of all loans on the house can’t exceed the fair market value of the house.

When this exception was first disclosed, lenders fretted that every consumer borrowing against his home equity would pretend that the money was for college tuition or medical bills, even if it wasn’t. Lenders feared they would be forced into the role of policeman to prove otherwise.

Instead, many lenders simply don’t ask about the purpose of the loan proceeds.

But the Internal Revenue Service will. If you try to deduct interest on a loan that exceeds the price plus improvements minus outstanding loans, and the proceeds really went toward medical or educational expenses, accountants suggest that you keep good records.

Is the tax break alone enough reason to justify taking out a home equity loan? Many lenders and tax specialists say it isn’t.

“When the consumer interest deduction is fully disallowed, we have a whole different issue,” said Security Pacific’s Weber. “But while we’re in the phase-out (period) and most of the deduction is still allowed, it just doesn’t make sense” to shift to a home equity loan strictly to keep the tax break.

Another consideration is the alternative minimum tax. Although most lenders aren’t publicizing this potential problem, taking out a home equity loan for purposes other than home improvements could subject the homeowner to a higher tax bill under the AMT. (See story on the AMT, Page 52.)

Consumers trying to finance a car also would be silly to opt for a 9% home equity loan just to get the tax break if they can get a 3.9% car loan from a Detroit auto maker on the car of their choice, notes S. T. R. Revell III, senior vice president and tax director for First Interstate Bank.

Keep in mind, however, that these are moot points if you can no longer qualify for itemizing your deductions, which will be the case for the 1987 tax year and thereafter for hundreds of thousands of taxpayers.

Besides the tax break, you should weigh the cost of switching to a home equity loan. Unless the lender is offering a special deal to attract your attention, expect to pay at least $250 in the up-front fees that lenders call closing costs. These are the costs of appraising your property, running a title search and credit check and preparing the documents.

On top of this, there may be loan origination fees, also known as points. Depending on your credit record and on how competitive the market is when you apply for the loan, you may pay anywhere from 1% to 7% of the loan amount, up front, in points. (The IRS, incidentally, has taken the position that loan-refinancing points aren’t fully tax-deductible in the year they are paid. Rather, the deduction must be spread out over the life of the loan.)

Consequently, one has “to look at how much interest you can legitimately hope to write off,” said First Interstate’s Revell. “If I knew I could expect only $200 in consumer interest expense deductions, why should I go out and incur a $250 appraisal fee?”

With home equity loan money flowing freely, you should look for a loan with no points from a lender who offers to pay all or part of the closing costs. Feldstein, of SMR Research, said such loans are widely available from reputable lenders.

Also be sure you get a loan without prepayment penalties. If interest rates start rising dramatically, you will want the option of paying it off early.

Perhaps your toughest task of all will be to compare rates. If you opt for a fixed-rate home equity loan, expect to pay at least 1 1/2 percentage points more than you will for a variable-rate second mortgage. In the Los Angeles area, you’re likely to pay 9.5% for a variable-rate home equity loan now, compared to 11% for a fixed-rate version.

If you decide on a variable-rate loan, insist on a loan cap, limiting how much the rate can rise over the life of the loan, urges the Consumer Credit Institute of the American Financial Services Assn.

Be on guard, too, for what Security Pacific’s Weber calls the “sucker rate.” These are low initial interest rates advertised by lenders who dramatically raise the rate a few months into the life of the loan.