Credit on the House: Use Caution
Thousands of Southland residents have found that they don’t have to sell their homes--most people’s biggest financial asset--to turn their equity into cash.
Spurred by aggressive bank marketing and tax benefits, homeowners increasingly are taking money out of their houses through home-equity credit lines and second mortgages.
Home-equity loans are easy to get and have lower rates than credit cards, but homeowners should be aware that they are pledging their houses as collateral to get cash today.
“If you are unable to make your monthly payments, you could be forced to sell your home,” notes a Federal Reserve Board publication.
But that risk doesn’t seem to be hurting demand for home-equity loans.
Home-equity lending has grown 30% to 40% each year for the past three years, said Cindy Cesena, consumer loans product manager at Home Federal. She said Home Federal expects to grant 4,000 to 5,000 of these loans this year.
Home-equity loans make up “a substantial portion of our overall consumer lending this year,” says Scott Allen, a Bank of America vice president.
Some banks--such as Wells Fargo--lend more through home-equity loans than by credit card, according to a report issued last year by SMR Research Corp.
This rise in home-equity lending is fueled by the gradual loss of tax deductions for interest payments not related to home ownership. By 1991, only mortgage-related interest will be deductible on tax returns.
“People are borrowing against their homes to buy a car,” said John Lindgren Jr., director of the Center for Financial Services Studies at the University of Virginia’s McIntire School of Commerce.
Lindgren notes “a phenomenal growth rate” of home-equity lending among eight California banks he surveyed last year, and he predicts that 1989 figures should be even higher.
The amount of total home-equity loans outstanding nationally are estimated to be at least $210 billion, according to the Federal Reserve Board.
Two main types of home-equity credit are available:
Most popular now are home-equity credit lines. Secured by a second trust deed on the homeowner’s property, these loans give borrowers a credit limit that they can draw against by writing checks.
Minimum payments generally cover only interest for 10 years. At that time, the borrower might have to make a “balloon payment” for the entire balance.
Second mortgages, or closed-end loans, are the other type of home-equity loan. They work like a homeowner’s first mortgage: Principal and interest are paid off together over a set period, generally not more than 15 years.
More efforts to market home-equity lending can be expected from banks, said Chris Wallner, vice president of asset production management at Security Pacific Bank.
But although Wallner cites the California real estate market as a force behind the loans, others are concerned about the ability of borrowers to repay.
“I get four to five mailings every month” from banks touting their home-equity products, said Gary Stroth, executive director of the nonprofit Consumer Credit Counseling Service of Los Angeles. “I can have $25,000 immediately,” he added. “Boy, it’s tempting.”
Lenders generally allow homeowners to borrow up to 75% or 80% of their equity, or the profit they would realize if they sold their home now.
Stroth is concerned about individuals with credit card debt who use a home-equity credit line to “pay off their bills and then get a feeling of comfort. Can you control yourself,” he asks, and not go back to using charge cards recklessly?
Consumer Credit Counseling sees about a dozen people each month who are in trouble because of home-equity debt, Stroth said. About 800 people come to the organization for counseling each month.
The eight large California banks in Lindgren’s survey report that only about .25% of their home-equity loans are delinquent, compared to a 1.5% delinquency rate on all consumer credit. But most home-equity delinquencies won’t show up for a few more years, according to Lindgren, since nearly 40% of those loans were granted last year.
Bankers report national delinquency rates of 1.22% on home-equity loans, according to the Consumer Bankers Assn., a trade organization representing banks and S&Ls; that serve consumers.
“People believe,” Stroth noted, that the bank already knows whether or not they can handle a home-equity loan. The bank “wouldn’t mail (the promotion) to me if I couldn’t” afford it,” they think.
“A two-edged sword” is how home-equity lending is described by Fritz Elmendorf, vice president of communications at the Consumer Bankers Assn.
With a credit line, the homeowner has a “lot of flexibility,” Elmendorf said. But it “puts the responsibility in the hands of the consumer.”
Convenience in obtaining money was the most-frequently cited advantage to home-equity loans, according to a 1988 survey of borrowers by the University of Michigan’s Institute for Social Research. Eleven percent of all homeowners have a loan secured by their home equity, in addition to first mortgages, the survey found.
More than 40% of the respondents said they were using the money for home improvements. Elmendorf suggests that home improvements are “the best possible use” of a home-equity loan. “It plows money back into the equity of a home.”
In addition, debt consolidation and major purchases--such as for automobiles or college educations--are the most-frequent uses of home-equity credit.
Besides considering the value of the home backing a loan, lenders also want to make sure each borrower has enough income to meet all his debt payments.
Security Pacific’s Wallner said the bank strives to ensure borrowers are “not strained” by their payments for first mortgages, home-equity loans and other debt.
But because home prices historically appreciate well in California, lenders here are more liberal than in other areas of the country. Bankers find that if home prices decline, delinquency rates on first and second mortgages rise.
Someone with $100,000 in annual income can get a home-equity credit line even if the payments will force him to spend half his income to meet his total debt payments, says Drew Tanaman, senior vice president in the mortgage lending division at Wells Fargo Bank.
But around the country, most lenders won’t grant a home-equity loan if the total debt would equal more than 40% of a borrower’s income, Elmendorf said.
When shopping for home-equity credit, your first consideration should be whether you need a second mortgage or a credit line. Second mortgages are used by a “traditional borrower with a specific need in mind,” said Home Federal’s Cesena.
Because they have set payment schedules for principal and interest, second mortgages offer less chance for a borrower to overextend himself than a home-equity credit line. In addition, interest rates on second mortgages now are about 1% below credit-line rates.
A line of credit is more useful for someone who wants access to money at different times. Having this established line of credit means the borrower doesn’t have to keep making loan applications and paying fees, explained Terri Chamberlain, a branch sales manager for Imperial Savings.
Interest is paid only on the amount of money used, much like the way credit card finance charges are figured. But interest rates on credit lines vary over time, just as an adjustable-rate mortgage does.
Combinations of second mortgages and home-equity credit lines, such as Security Pacific’s “Equity Maximizer,” are useful in certain situations.
For instance, someone making home improvements who does not know the final cost might use this product. Most of the home-improvement debt can be paid with a low-rate second mortgage, with additional money available, if needed, through the line of credit.
When shopping for home-equity credit, Elmendorf said to ask about up-front fees, interest rates, repayment terms and annual fees.
Disclosure regulations that went into effect in November require that lenders tell credit-line applicants what the current interest rate is and how high it could go.
Fees and potential balloon payments also must be disclosed up-front, said Peggy Miller, a legislative representative at the Consumer Federation of America.
Miller said that the law keeps lenders from raising their rate structure or canceling credit lines without cause. She suggested that anyone with a credit line established before November check the contract for so-called “escape clauses” that give lenders the right to make future changes.
Despite the new regulations, earlier contracts stand as written. Borrowers should “renegotiate” with lenders, Miller said, or shop around for a new credit line to replace the old one.
Before choosing one, try to determine how you will use a credit line. If you will be using it for years, consider picking a lender that doesn’t charge an annual fee. Even if you pay higher up-front costs, you can save money over time.
You might also want to anticipate how a credit-line rate will adjust. Banks that peg their interest charges to certificate of deposit (CD) rates often have lower credit-line rates.
However, they fluctuate more than loans tied to the prime rate. CD rates are adjusted as often as every week, while some prime-based lenders adjust their rates quarterly.
Perhaps the most important element in shopping for a home-equity loan is knowing before you use it how you will make the payments. As borrowers throughout history have found, it’s often easier to get a loan than it is to pay it off.
COMPARISON OF HOME EQUITY CREDIT LINES
Bank Rate Closing Costs Bank of America CD rate + 3.50% $400 with 5.0% lifetime cap $200, 7.5% lifetime cap First Interstate prime + 2.00% $225 flat fee Coast Savings prime + 2.00% $500 for $50,000 line + $125 document prep. Security Pacific CD rate + 3.50% $0 with 10% lifetime cap 1 pt. with 5% lifetime cap 2% annual cap Imperial Savings prime + 1.75% $387 or less 18% lifetime cap Wells Fargo CD rate + 3.60% $450 for up to $100,000 line Home Federal prime + 2.00% 12.5 points + about $150
Bank Fees Bank of America $75 a year $50 a year First Interstate $0 Coast Savings $0 Security Pacific $100 a year Imperial Savings $50 a year Wells Fargo $45 a year Home Federal $45 a year
