Homeowners Bank on Equities for New Loans

WASHINGTON —  A man’s home may be his castle, but soon it’s likely to be his bank as well.

The popularity of home-equity loans--which allow a homeowner to borrow against the appreciated value of a residence--has tripled during this decade. Last year homeowners borrowed $75 billion with their homes as collateral, according to the National Second Mortgage Assn.

Executive director Perk Lodge estimates there is about $2 trillion in unencumbered equity in residential real estate, waiting to be tapped like sap in a maple tree. If tax reform wipes out the deduction for interest on all consumer loans except first and second residential mortgages, there will be buckets under every tree, he predicts.

People are being urged by lenders to use the equity in their homes to finance everything from new cars to shopping sprees. “We anticipate home-equity loans will be one of the most popular ways of borrowing money,” said Ann McNerney, assistant vice president of Dominion Federal Savings & Loan.

The home-equity loan can become a “giant credit card,” in the words Scott McCleary of the Mortgage Bankers Assn.

Yuppie Second Mortgage

Home-equity loans have been labeled the yuppie second mortgage because they are marketed to upscale customers with nice homes in nice neighborhoods and incomes to match. A typical lender will let homeowners add together first and second mortgages totaling 80% of the value of the house, provided the borrowers’ total debts of all types do not exceed 40% to 45% of their gross income.

About one-quarter of all second mortgages are now revolving lines of credit. By avoiding the terms second mortgage and home-improvement loan, the lenders hope to avoid the stigma attached to second trusts.

Home-equity loans generally carry a variable interest rate pegged to the prime rate or some other index reflecting the lender’s cost of funds.

Despite the rate competition, the combination of good collateral, good credit risks and variable rates means home-equity loans are regarded as a win-win proposition for financial institutions.

Are they a no-lose proposition for customers, too?

That depends, a review of home-equity financing for some specific needs suggests.

Updated Version

A home-equity loan is just an updated version of a second mortgage run through a computer. Instead of borrowing a set amount at the start and paying a fixed rate on interest and principal until maturity, the customer gets a pre-approved line of credit, on which he or she can write checks when needed, repayable as desired. The line of credit can be used indefinitely up to the limit of the equity in the house.

The monthly payment on a typical home-equity credit line is 2% of the outstanding balance; that includes interest and principal, but since the monthly principal repayment is small the loan can take a long time to repay if you only make the minimum payment.

Other equity lines allow the borrower to pay interest only for 10 years, after which the entire principal is due in a balloon payment. Then the borrower has the choice of paying up or refinancing. About three-quarters of lenders say they will roll over a balloon loan on which payments are current into a fixed rate loan, but there is no guarantee.

“The real dangers lurk in the home-equity credit line’s repayment structure,” warns Mortgage Bankers Assn.’s McCleary. “If you cannot renegotiate the loan, you may find yourself owing the full amount of the principal at the end of (the prescribed term). And if you cannot pay the full amount, you could lose your house.”

Second-mortgage lenders have the same legal right to foreclose as first-mortgage holders. The foreclose rate for all types of second trusts is 0.5%, according to Lodge. That could change if Americans start using home-equity loans like credit cards.

Depends on Costs

Deciding whether home-equity loans are a good deal financially depends to a large extent on how much the up-front costs push up the true rate over the advertised rate. These costs typically include appraisal of the house, attorney’s fee, title search and insurance, recording fee, credit report and sometimes annual fee and points on the loan.

The Washington Post asked the Washington financial-consulting firm of Dennis M. Gurtz & Associates to calculate rates on several types of loans for two hypothetical cases. Gurtz and his associate Harry E. Tutwiler selected typical terms from local banks and thrifts.

In the first instance, a borrower seeks a loan of $10,000 for three years to buy a new car. According to Gurtz, a bank auto loan would cost between 10.25% and 10.5%. That is well above the subsidized rates offered by manufacturers on some slow-selling cars. (If the manufacturer adds the cost of subsidizing the low-rate loan to the sale price of the car, however, the true difference between the two methods of financing would be smaller.) An overdraft checking account or a credit card carrying 14% to 18% interest would be an even more costly way to finance a car.

The two most competitive rates are an unsecured personal loan at 2 points over prime or 10% and a home-equity loan at 1.5 points over prime or 9.5% plus closing costs of about $450.

Gurtz said a 7.5% teaser rate for the first few months results in a savings of only $20 to $40 per loan. He calculated the real annual rate on the home-equity loan amounts at 12.43% and amortized the home-equity loan over three years to compare it to conventional car financing.

Most Attractive Deal

Under the present federal income-tax code that allows deduction of consumer interest, the most attractive deals is the unsecured personal loan at 10%.

If tax reform removes the consumer interest deduction, however, the home-equity loan will be cheaper, amounting to an after-tax rate of 8.98% for a person in the 27% bracket.

Another case involves parents who want to borrow $12,500 a year for four years to pay their child’s college tuition. They may wish to withdraw equity by refinancing their home, take out a fixed-rate second mortgage or open a line of credit with the house as collateral.

The planners found that refinancing to borrow $50,000 at 10% for 15 years with closing costs plus 3 points results in an effective annualized cost of about 11.3%. A second mortgage of $50,000 at 11.25% for 15 years (plus costs and 2 points) works out to an effective annualized cost of about 12.7%. The 10-year line of credit, 9.7%.