Just say no to home equity loans

"Cash out your home equity while rates are low." "Use your home equity as a checkbook." "Take that vacation you've always wanted." "You've earned it, now use your home for the good things in life you couldn't enjoy before." "Pay down your credit card balances, buy a new car, consolidate loans—just 3.9 percent interest."

You've seen the ads. They're everywhere: radio, television, newspapers, and dinner-hour telephone calls. During a typical month, I receive a dozen or more junk mail offerings, nearly all of which use some type of deceptive bait.

Today's trick offering: "Need a fixed mortgage payment? How about 2.2 percent for five years?" After reading the fine print, did I learn that the lender really would charge me a fixed-interest rate of 2.2 percent for five years? Of course not. In fact, the loan was variable rate with negative amortization. See how the ad copy is written: "fixed mortgage payment," not fixed-rate interest. As a smart reader of Mortgage Secrets, you probably noticed that sleight of hand. But many borrowers aren't that perceptive. That's why the ads pull in the gullible.

Lenders push home equity loans with reckless abandon. Americans have endangered themselves with more than $1 trillion in home equity debt. In fact, to call it home "equity" debt stretches the semantics because a growing number of Americans are flipped upside down with second, third, and sometimes fourth mortgages. Millions owe more than their home is worth. They're chained to debt for as far into the future as they can imagine. Or they face the peril of foreclosure and/or bankruptcy.

The Wealth Destroyer

Just 25 years ago, most homeowners optimistically counted the years and months that would pass before they paid off their home loans. To celebrate this happy event when it finally arrived, "free and clear" homeowners would invite friends and neighbors to a mortgage-burning party. Take out a second mortgage (as home equity loans were then called)—unthinkable! Only dire emergencies could force such imprudent borrowing. That's why nearly all members of the Greatest Generation crossed into retirement as homeowners—not debtors.

From Fiscal Watchdogs to Selling Loan Products

Sometime in the mid- to late 1970s, banks changed. Loans became products that banks wanted to sell. They reversed their long-established role as fiscal watchdogs. Rather than counsel people against the evils of needless borrowing, bankers blitzed the public. Banks mass-mailed unsolicited credit cards to people they had never seen or heard of.

"Spend, borrow; borrow, spend," the bankers urged. "No credit, slow credit, bad credit, no problem. If you own your own home, we've got a loan for you. No equity needed." No wonder bankruptcies have climbed to levels 10 times higher than they were several decades ago. Likewise, mortgage delinquencies, defaults, and foreclosures are climbing in response to the 2001-2006 orgy of lending to borrowers who did not understand— or could not afford—the loans they were given. Of course, loan reps earn their fees and commissions from bad loans as well as good ones.

Weakness of Will and Financial Discipline

In adopting the sales approach, the bankers knew their marks. They knew that millions of people would jump at the chance to spend and borrow now—then worry over the destructive consequences later. You may have read news articles that talk about "the shrinking middle class." In its place we see great growth in families and households with little or no positive net worth. But the opposite is true, too—great growth in the number of people who are prospering. And no, income differences do not satisfactorily explain the wide disparities in wealth.

What does account for these discrepancies? Stanley and Danko (The Millionaire Next Door) coined the terms UAWs (under accumulators of wealth) and PAWs (prodigious accumulators of wealth). The critical distinction: spending and borrowing versus saving and investing. On a scale of 1-10, UAWs score 8-10 on spending and borrowing; 0-3 on saving and investing. PAWs reverse those scores: 8-10 on saving and investing; 3-6 on spending and borrowing.

Just Say No

Home equity borrowing vanquishes your capacity to build wealth. If you do use it, use it only for productive investment that offers low risk for good returns. Never eat seed corn. Yet, the data on home equity loans show overwhelmingly that most borrowers waste this money with imprudent spending (which includes ill-considered home improvements, such as the faddish—yet absurdly expensive—granite countertops, hot tubs, swimming pools, and $5,000 outdoor grills). If you pay cash for extravagances, okay—if you like to throw money away. But to build wealth, never squander your home equity to buy such luxuries.

What about bill consolidation, or paying off high interest rate credit card balances? Again, prudence says no.

Rather than pay less interest, borrowing to pay bills most often leads to even larger payments for interest and higher amounts of debt. Why? Because borrowers who wrap their credit card balances and other bills into home equity loans (or refinances) temporarily minimize the pain of debt. Yet, with a longer term and lower payments, the debt generates higher long-term costs. Even worse, many borrowers run their credit card balances up to where they were before. "Uh-oh, better increase the HE-LOC limit or refi again. Thank goodness the home went up $25,000 in value last year." Wealth destruction continues.

What to Look for in Home Equity Loans

If after review of the numbers you still decide to load up with debt, examine the terms of your home equity loan (lump sum borrowing) or home equity line of credit (spend your equity directly through the checks or credit card the bank gives you). Borrow with the same savvy you would apply to any other home finance agreement that you enter into. No matter what misleading advertising ploys the lender coins, a home equity loan carries the same types of terms, conditions, obligations, and rights of foreclosure as does any other mortgage.

No, let me revise that statement. Don't merely borrow with savvy; borrow with magnifying-glass scrutiny. Lender hype and fine-print gotchas multiply with home equity loans.

Most people pursue purchase mortgages or refinancing out of need. These loans are bought as much as they are sold. This is not true of home equity loans. Ninety percent of the time, lenders sell these loans. Relative to their dollar volume, lenders spend far more to promote and market home equity loans. Also, predatory lenders stalk the jungles of home equity lending in fierce competition with other members of their species.

Specifically, here are several of the more important terms and conditions to watch out for:

  • ARMs: Adjustable-rate mortgages account for most home equity loans. Scrutinize caps, adjustment periods, and margins.
  • Teaser rates and payments: Nearly two-thirds of home equity loans start with teaser rates. How long will it last? How high can it jump? Also, I have noticed a trend toward "teaser payments." Lenders know people care more about the amount of their required payments than the level of their interest rate. So, ads tout "fixed low payments" and slip negative amortization through the back door.
  • Prepayment penalties: Great teaser rates often come with prepayment penalties. Lenders don't want you to grab a below-market rate for three or six months and then bail out before they've extracted their pound of flesh.
  • Balloon payments: When does the loan fall due? Is it callable prior to that date? Ifyou wish to renew, must you requalify? Must the lender order a new appraisal?
  • Loan fees: Usually not as bad as with purchase/refi mortgages, but some lenders will sting you if you're not swatting as necessary.
  • Maintenance and inactivity fees: Some borrowers set up home equity lines of credit only to be used in emergencies. The lender may require you to either borrow some stated minimum amount, or pay a fee for the privilege of refraining.

An open line of home equity credit—whether used or not—can reduce your credit score. If you plan to refinance or buy another property anytime soon, place this borrowing within the context of your total credit profile. The AU/credit-scoring program could conclude that you're overextended.


Secrets of the Credit Industry

Secrets of the Credit Industry

Legal strategies that credit bureaus, creditors and debt collectors do not want you to know! How to use consumer credit protection laws, without hiring a lawyer, and without going to court! At some point in your life, either you, or someone you know will need this information.

Get My Free Ebook

Post a comment