To Many Homeowners, Equity Equals Good Terms for a Loan
Over the past year, soaring housing prices have been providing a windfall for many Orange County homeowners needing some extra cash.
Fueled by strong demand and limited supply, the median price of a single-family house in Orange County hit a record $237,409 on the resale market in February. That’s an increase of $57,652--or 32%--in just 12 months.
Prices have risen so quickly that people who have owned their homes for just a few years are finding that they have built up $100,000 or so in equity--the difference between what their houses are worth and what they still owe.
In increasing numbers, owners are converting that equity into cash. They’re doing it by taking out home equity loans or home equity lines of credit--two types of financing that have surged in popularity with the heat of the housing market and the changes in tax laws.
Many borrowers are using the funds to fix up their houses by building additions and otherwise making do with their current quarters because they cannot afford to buy bigger houses, lenders say.
“With the cost of housing today, there’s a greater focus on remodeling a home rather than moving up to a bigger house, which carries a higher price and higher monthly payments,” said Michael E. Cichon, senior vice president for residential lending at Great Western Bank, a Beverly Hills savings and loan.
Some homeowners are refinancing original mortgages to get extra cash, but refinancings have slowed considerably. That’s because interest rates have risen considerably and because many of the people who took out mortgages when rates were high several years ago have already have refinanced them.
Refinancing also takes longer, costs more and the qualification rules are stricter, although the interest rates would be lower than those for home equity loans, lenders say.
Besides financing home improvements, equity loans and credit lines are often used to consolidate consumer debts such as automobile loans and credit card charges, lenders say. Other purposes for them include paying off medical bills and college costs and financing a small-business venture.
Some affluent Orange County residents are borrowing against the equity in their homes to make down payments on duplexes, apartments and other rental properties, said Stephen P. Renock IV, senior vice president at Shearson Lehman Hutton Mortgage Co. in Newport Beach.
All of those are considered to be good reasons to take out equity loans, because in each case there is some genuine benefit derived. But lenders are also finding that borrowers are using equity loans for frivolous expenditures that they often cannot afford such as luxury cars, expensive vacations and even gambling losses.
Borrowers who fail to make these loan payments won’t be confronted by collection agencies threatening to ruin their credit records. Rather, they will hear from banks who have the legal right to take their homes away. The ultimate risk in an equity loan is foreclosure.
“The bottom line is that a home equity loan is not a safe solution for a poor money manager,” said Kenneth Slezak, owner of Vista Marketing Services, a Huntington Beach consulting firm for the banking industry.
In fact, consumers who are having trouble handling their debts usually are dissuaded from using a home equity loan to consolidate them, said Carl F. Lindquist, president of Consumer Credit Counselors of Orange County, a nonprofit organization that counsels borrowers overburdened with consumer debts.
Lenders say an important motivation behind equity loans being used to consolidate debts has been the change in federal tax laws. Under the 1986 Tax Reform Act, the deductibility of consumer loan interest is being phased out, but interest paid on home loans remains deductible.
Only 40% of the interest paid on consumer debts last year was deductible on 1988 income tax returns. And next year, said Robert J. Weber, vice president and product manager for Security Pacific National Bank’s home equity programs, the deduction for consumers “drops to 20% of the interest they’re paying this year. Most people probably are consolidating their consumer debts into equity loans right now.”
Interest on home equity loans is deductible as long as the loan does not exceed $100,000 or the owner’s actual investment in the house, whichever is less. The investment amount consists of the down payment, any mortgage principal already paid off and any amount paid for home improvements; it does not include appreciation.
Therefore, someone who bought a house for $150,000, built a $30,000 addition and still owes $100,000 on the mortgage could borrow up to $80,000 through a home equity loan whose interest would be tax-deductible.
If the home has appreciated enough to be valued at, say, $250,000, the owner could take out a bigger loan, but interest paid on any amount over $80,000 would be deductible only if the money is used for home improvements, education or medical expenses.
“In today’s environment, the first thing you should do is talk to a tax adviser,” Weber said. “Then you should look at why you’re taking out the loan.”
Home equity loans are also known as junior mortgages. A borrower receives a fixed sum that is typically paid back in equal monthly installments over a period of 5 to 15 years. The lender has a secured interest in the residence.
Home equity lines of credit are similar, except that a borrower is given a spending limit like that on credit card accounts rather than a fixed sum of money. The borrower can draw cash and pay off the loan much like he or she would a credit card balance.
Like most mortgages made today, equity loans and credit lines generally have adjustable interest rates instead of fixed rates. Those rates typically float at a level of 2 to 3 percentage points above the prime lending rate, which now is 11.5%. The interest rates of some equity loans, however, are figured using other indexes that fluctuate less than the prime rate.
Unlike mortgages, however, equity loans and credit lines do not have all the same tax benefits. The up-front fees such as points and closing costs, for instance, are fully deductible for mortgages used to acquire property but not for equity loans.
And just as for adjustable-rate mortgages, there are many variations in the terms for equity loans.
Shearson Lehman Hutton, for example, offers a “prime only” equity line, which means that the interest rate is the same as the prime rate. Most lenders make loans at the prime rate only to their best customers, and Shearson tends to limit its loans to its more affluent clients.
Security Pacific has touted its equity loans in newspaper advertisements under a headline stating: “No Fees. No Points. No Closing Costs.” Those terms refer to the up-front charges borrowers usually pay in home loans of any kind.
And Downey Savings & Loan in Newport Beach has devised a fixed-rate equity loan, something its packagers believe is a first for the area, said Thomas DiLeo, the S&L;’s loan production manager.
Because lenders have had little experience with the newer kinds of equity loans, there is little data to determine how well consumers have borne the added debt burden.
And since most houses are appreciating rapidly in Orange County, the risk of default here is low--at least for now.
“We have not seen many problems recently, solely because the price of real estate has soared at unprecedented levels in California,” said Shearson
Lehman’s Renock. “If you look at Orange County in particular, it’s hard to sell a home a year after it’s purchased and not come out with cash in your pocket.”
About the only threat to that optimistic assessment--and it’s a threat that’s beginning to bother lenders more and more--is the possibility of stagnant or even declining housing prices, Renock said.
If that should occur, some people would simply walk away from their homes, he said, and lenders would be stuck with a lot of foreclosed real estate and big losses.
HOME EQUITY LOANS*
UP TO $50,000 IN ORANGE COUNTY
No. of Total Month Loans Amount January 2,961 $80,646,829 February 3,030 82,115,269 March 4,257 118,352,385 1989 Total 10,248 281,114,483
* Includes small number of refinancing loans
Source: TRW Real Estate Market Information Services
