Financial Planning: A Midyear Guide 1987 : part four: Borrowing : New Home Equity Loans: the Key Word Is Caution

Home equity represents one of the nation’s biggest savings pools. Combine that with a new tax law making that pool more attractive as a financing tool and you’ve got action.

You’ve also got controversy.

The massive federal tax reform passed by Congress last year phases out writeoffs of consumer interest charges. Those writeoffs drop to 65% this year and will be at zero by 1991.

But the law continues to allow full deductibility of mortgage-related interest on first and second homes. So the home equity loan is the newest lure for consumers who want to go on spending binges--or simply consolidate their old debts.

It’s easy to figure out what is available to you: Say you bought a house for $200,000 and you spent $25,000 on improvements. You have paid your first mortgage down to $175,000. You could get a home equity loan for up to $50,000 for any purpose and deduct the interest expenses. You can borrow more and deduct the interest if the money is for medical or educational expenses.

Attractive packages and deals are luring customers into banks and savings and loan institutions by the hundreds of thousands, and the American Bankers Assn. predicts that home equity credit will double this year from the $40 billion outstanding last year.

Two basic home equity loan products--often with several variations--are being offered. One is the traditional second mortgage. You borrow a lump sum, often equal to the equity in the home. It comes with fixed and variable rates of interest, which usually have some limits on how high or low the rate can go.

The other, more flexible--and more controversial--product is the home equity line of credit. You have a line of credit secured by your home equity, and you can draw on it any time you wish. Unlike a second mortgage, you aren’t charged interest until you begin drawing on the credit line. The rates are usually variable but, unlike the second mortgage, there is no cap.

The action is picking up, particularly on the home equity line of credit, and as it does, a brisk debate has been set off between financial institutions looking aggressively for new customers and consumer groups concerned that some homeowners may borrow unwisely and put their homes at risk.

Even financial planners disagree on the wisdom of using your home equity to set up a line of credit.

For Melvin Nefsky, a certified public accountant and business manager in West Los Angeles, home equity credit represents “for some people” a great opportunity to pay off credit card bills and car loans, or purchase a new car, and still write off all the interest.

“The key is discipline,” Nefsky said. “If you are disciplined enough to spend the equity credit wisely and to make your payments, why not use it and get the writeoff advantage under the tax law?”

Lewis Wallensky, a Century City financial planner, agrees: “I encourage using home equity to consolidate consumer debts or to restructure your monthly cash flow, although I do not advise using it to invest, say, in the stock market.”

On the other side is T. Kevin Denny, a CPA and financial adviser in Glendale.

“My general advice is to avoid home equity loans,” Denny said. “It is important that a person with home equity not borrow against it to finance short-term items like cars. You should match the term of the liability to the term of the asset you are acquiring.” For example, a new car may last only eight years but the life of the loan could be twice that.

Duglas Wright, a Huntington Beach financial planner, also expressed particular concern about the home equity line of credit.

“It looks so easy,” Wright said. “You know, ‘Get your money when you want it.’ But you have to remember that your house is on the line. Credit card companies are flexible about rearranging debt payments, but the question is, will the banks be so flexible if you can’t pay your home equity loan and your house is the collateral?”

A borrower’s ability to make payments is of particular concern to Gail Hillebran, staff attorney for Consumer Union in San Francisco.

Most home equity lines of credit offered today, she notes, do not have caps on their interest rates.

“Mortgage interest rates today are in the range of 10%, but don’t forget that in the late 1970s they rose to 18%. So if we experience that again in the next 15 years--the term of a home equity loan--some people could not make the payments and would lose their homes.”

Hillebran also worries that opening a home equity line of credit

may not be taken as seriously by some borrowers as would taking out a traditional second mortgage.

“You may not think of home equity credit as a major obligation, but it most definitely is,” she said.

Some home equity loans come with a large balloon payment at the end, and those should be avoided, Stephen Brobeck, executive director of the Consumer Federation of America in Washington, said.

“The balloon is most likely to appear when one tries to sell one’s home,” Brobeck said. “The seller then would have to move into inferior housing, since he would have to use a portion of the equity realized in the sale to pay off the balloon.”

Brobeck points out that homeowners often overlook a second mortgage as an option, for several reasons:

“First, home equity loans are being heavily promoted by banks and savings and loans,” he said. “Second, they are being advertised with somewhat lower starting interest rates than traditional second mortgages. And third, I think a lot of consumers are attracted by the credit line idea.

“With a second mortgage, you usually decide what you want to spend it on and then go get the money. But with the equity credit line, you just open the line and decide later. It’s the freedom of the thing.”

Brobeck believes that home equity loans are so hot--and, potentially, so controversial because of deceptive advertising and the threat of eventual foreclosures--that “Congress will hold hearings on this by the end of the year.”

But James W. Christian, chief economist with the U.S. League of Savings Institutions in Washington, is not so sure.

“By and large, the attitude to take on home equity loans at this point is that we aren’t sure how pervasive they are, and it is premature to be talking about legislation,” Christian said.

“I think worries about people dashing off to vacations in Fiji or behaving irresponsibly are unfounded. You need to remember that homeowners are not easy pickings--they’re pretty sophisticated people.”

If you do decide that the new tax law and your own particular circumstances make a home equity line of credit a sensible option, groups such as Consumer Action and the Consumer Federation of America suggest the following:

Remember that you can still write off 65% of consumer debt in 1987, so the tax argument may not be as persuasive now as it will be in a few years.

Give serious consideration to the second mortgage, lump-sum equity loan. It usually has more conservative terms, although it does not have the easy access of the home equity credit line.

If you choose the home equity line of credit, remember that most do not have caps on interest rates, so you should be sure of your ability to handle bigger payments later if interest rates go up.

Avoid loans with balloon payments if at all possible.

There are fees involved with setting up most equity lines of credit, even if you never use the money. In most cases the fees are based on the total line of credit, not on what you actually borrow.

Keep in mind, too, that while the interest is fully deductible, the fees are not, according to the Internal Revenue Service. Points charged for refinancing are deductible over the life of the loan.

Add up the fees, figure in the tax law changes and determine if it still makes sense to go this route to get cash.

Remember: If you get in over your head on credit cards, the worst that can happen is that you’ll get a bad credit rating and years of settlement payments. But if you can’t make the payments on your home equity loan, you could lose your house.

Perhaps the best advice comes from Jack Levine, first vice president for product management at Security Pacific National Bank in Los Angeles.

“Know exactly what your situation is and what you need,” Levine said. “And ask your banker lots of questions.”

“Know exactly what your situation is and what you need. And ask your banker lots of questions.”