Liz Pulliam Weston
Millions of Americans are using home-equity loans and lines of credit for splurges. That's risky. But for better investments, these loans can make sense.
Bankers love it when you borrow against your house. That's reason enough to be wary of home-equity lending.
Yet millions of Americans are buying lenders' pitches that our homes are a good source of funds for whatever our little hearts desire, from Super Bowl tickets to exotic vacations to investments in stocks and bonds. That lust for cheap cash has turned home-equity lending into the fastest-growing, and very profitable, area of consumer loans.
Mainstream home-equity lending soared 33% last year according to SMR Research, with new borrowing at nearly quadruple the level of just five years ago. The amount we owe on home-equity loans and lines of credit, $719 billion, now exceeds the balances on our Visas, MasterCards and other general-purpose credit cards.
| Home-equity lending skyrockets | |||
|---|---|---|---|
2004 | 1999 | Increase | |
New borrowing | $431 billion | $114 billion | 278% |
Total owed | $719 billion | $267 billion | 169% |
Source: SMR Research
Those figures don't include home-equity lending to people with troubled credit. So-called subprime mortgage lending rose 60% last year, said SMR vice president George Yacik, to $516 billion. Although the figure includes first mortgages, Yacik said most subprime home lending involves home-equity loans and lines of credit.
Good for banks, risky for consumers
"There's no bad debt to speak of," Yacik said. "(The borrower's) home is at stake, and they have to be deeply extended not to pay their bill."
Rising home prices mean that banks can get their money back even if they have to foreclose, and troubled borrowers typically sell the home or refinance before that happens.
The low default rate masks the real problem with home-equity lending: Most borrowers are using the loans and lines of credit to fritter away their long-term wealth on short-term spending.
"I recall one computer magazine a couple of years ago that recommended that people get home-equity loans or lines of credit to purchase computers," said Andrew Analore, editor of Inside B&C Lending, an Inside Mortgage Finance publication. Then there was the recent Associated Press article about fans calling mortgage lenders to finance Super Bowl tickets, on top of the more usual borrowing to fund big-screen TVs to watch the game.
"That kind of stuff can be problematic," Analore said, "because people sometimes don't understand that their house is on the line if, for some reason, they are unable to pay for their new computer or big-screen television."
Understand loan types
If you're thinking of literally betting your house with a home-equity loan or line of credit, you should clearly understand how these loans work, when to use them and how to get the best deals.
First, the basics. There are two types of home equity lending, loans and lines of credit:
- Home-equity loans are installment loans, like regular mortgages and auto loans. You're given a certain amount of money which you typically receive all at once and pay back according to a set schedule, over time. Home-equity loans usually come with fixed rates and fixed payments.
- Home-equity lines of credit, by contrast, work more like credit cards. You're given a credit limit that you can borrow against, and paying down your debt frees up more credit that you can potentially spend. Home-equity lines of credit have variable interest rates that are typically tied to the prime rate.
Unlike credit cards, however, home-equity lines of credit usually aren't open-ended. For the first 10 years or so, you can draw as much as you want from your credit limit, and you only need to pay the interest charges. In the next stage, however, the "draw" period ends and whatever debt you have left is "amortized," which means you need to start paying principal and interest to retire your debt. (Some lenders let you renew your draw period, but eventually the debt has to be paid off.)
| Average amounts borrowed | |||
|---|---|---|---|
Types | 2004 | 1999 | Increase |
Lines of credit | $77,526 | $49,260 | 57% |
Loans | $62,112 | $35,672 | 74% |
Source: Consumer Bankers Association
With either type of borrowing, you're pledging your home as collateral. If you fall behind on your payments, the lender can foreclose and take your house.
When to use these loans
A line of credit may be a better option for shorter-term borrowing, or when you want to be able to tap your home equity to cover emergencies.
You also might consider a loan, rather than a line of credit, when you want to lock in a low interest rate in a rising-rate environment, like we have now. In recent months, the rates on lines of credit have been ratcheting up with each Federal Reserve hike.
The gap has narrowed considerably from a few years ago, when lines of credit averaged more than two percentage points less than loans. When the gap is that big, it may make sense to take the risk of choosing a variable-rate line of credit over a fixed-rate loan.
5 tips for smart borrowing
Compare the rates. The rate you'll be offered on a loan or line of credit depends heavily on your credit score -- perhaps too much, according to one banking regulator. Julie Williams, acting head of the U.S. Comptroller of the Currency, said in December that home-equity lenders were relying too much on "risk factor shortcuts" like credit scores, which reflect consumer's past credit performance but that don't factor in how well they'll handle a big increase in their debt.
If you have an excellent score of 760 or above, you should be able to win a home-equity line of credit for half a point below the prime rate, said Chris Larsen, CEO of E-Loan. A good score of 700 to 759 should win you a rate equal to prime. (To see current rates on lines of credit and loans by credit score, visit the Loan Saving Calculator at MyFico.com.) People with mediocre to poor credit can pay 1 to 5 points over prime, or more.
Avoid the fees. If you have decent credit, you shouldn't have to pay any application or appraisal fees to borrow against your home. (Make sure the lender isn't tacking fees onto the loan amount, and that you're not paying a "broker fee" if a third party is helping to arrange the loan.) You may have to pay recording fees, which should be minimal, and an annual fee on your credit line.
Know the tax rules. Home-equity borrowing is often touted as superior to other consumer debt because you can deduct the interest. But that's not always true. You have to be able to itemize, which most taxpayers can't do because they don't have enough deductions.
If you have excellent credit, for example, you might be able to get a new car loan for a fixed rate that's actually lower than what you'd get on a variable line of credit. Unless you're able to itemize, the fixed-rate auto loan is clearly the way to go.
Also, know that even if you do get a deduction, the tax break is limited to interest on loan amounts of $100,000 or less; if you've borrowed more, the interest you pay on amounts over $100,000 can't be deducted.
Know what you're risking. A home can be a good way to build long-term wealth -- as long as you're not constantly draining it away. Every dollar of equity you borrow is a dollar that can't be used to buy your next home when you're ready to trade up, or to fund your retirement when you're ready to downsize.
Be particularly wary of using home equity to pay off credit cards or other short-term debt. Often you'll just wind up deeper in debt because you haven't addressed the basic overspending problem that got you into trouble in the first place.
Also, don't assume that using equity to pay for home improvements or education is always a slam dunk. Not all home improvements add value and it's easy to go overboard with student-loan debt, as well. It's up to you to set reasonable limits on your borrowing and to make sure that what you're buying is worth the wealth you're committing.In general, you don't want the term of your borrowing to last longer than what you've purchased. If you use home-equity borrowing to buy a car, for example, try to pay off the balance in a few years -- and definitely before you trade in for a new vehicle.
Keep some headroom. You should try to keep a cushion of at least 20% equity in your home. If your combined mortgage and home-equity borrowing exceeds that amount, you'll pay higher interest rates. You're also cutting yourself off from an important source of funds in an emergency.
"Very few families are good at savings. In effect, their home equity is their 'rainy day' fund," Analore said. "It's the only source of capital that many people will be able to tap in an emergency. And it won't be there if the home has already been leveraged to fund short-term consumption."
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