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 Association.
Executive Director Perk Lodge estimates there is some $2 trillion in unencumbered equity in residential real estate waiting to be tapped like sap in a maple tree. If tax revision 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 and Loan.
The home-equity loan can become a "giant credit card," in the words of Scott McCleary of the Mortgage Bankers Association.
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 first and second mortgages totaling 80 percent of the value of the house, provided the borrowers' total debts of all types do not exceed 40 to 45 percent 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. A war among Washington-area banks and thrifts has driven rates as low as 7 1/2 percent -- for at least the first few months of the loan. After the promotional, or teaser, rate runs out, most lenders charge 1 1/2 points above the prime. With the prime at 8, that means 9 1/2 percent home-equity loans.
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 on the specific needs, a review suggests.
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 preapproved 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 approved.
The monthly payment on a typical home-equity credit line is 2 percent of the outstanding balance; that includes interest and principal, but because the monthly principal repayment is small, it can take a long time to pay off the loan if a borrower makes only the minimum payment.
Other equity lines allow the borrower to pay interest 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 MBA'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 foreclosure rate for all types of second trusts is one-half percent, according to Lodge. That could change if Americans start using home-equity loans like credit cards.
Bill Cooper, senior vice president of American Security Bank, said he doesn't anticipate any problems with its home-equity loans.
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 and Associates Inc. 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 1/4 and 10 1/2 percent. (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 percent interest, would be even more costly ways of financing a car.
The two most competitive rates are an unsecured personal loan at 2 points over prime, or 10 percent, and a home-equity loan at 1 1/2 points over prime, or 9.5 percent, plus closing costs of about $450.
Gurtz said the 7 1/2 percent teaser rate for the first few months results in a savings of $20 to $40 per loan. He calculated the real annual rate on the home-equity loan amounts at 12.43 percent and amortized the home-equity loan over three years to compare it with conventional car financing.
Under the present federal income tax code, which allows deduction of consumer interest, the most attractive deal is the unsecured personal loan at 10 percent.
If tax revision removes the consumer interest deduction, however, the home-equity loan will be cheaper, amounting to an after-tax rate of 8.98 percent for a person in the 27 percent bracket.
Another case involves parents who want to borrow $12,500 a year for four years to pay their child's college tuition. They might wish to withdraw equity by refinancing their home, taking out a fixed-rate second mortgage or opening a line of credit with the house as collateral.
The DMG planners found that refinancing to borrow $50,000 at 10 percent for 15 years, adding closing costs and 3 points, results in an effective annualized cost of approximately 11.3 percent. A second mortgage of $50,000 at 11 1/4 percent for 15 years (plus costs and 2 points) works out to an effective annualized cost of about 12.7 percent. The 10-year line of credit works out to 9.7 percent.
The home-equity loan appears preferable in this situation, not only for its low rate, but because the other two loans give the parents the full $50,000 at the outset and then leave it to them to invest the unused portion. To come out even, they would have to earn the same rate on the invested portion as they pay on the amount of the loan utilized.
Gurtz and Tutwiler concluded that a home-equity loan would not be preferable for a small amount borrowed for a short time. They found it would not be available to someone with high equity and low income, like an elderly couple desiring a large loan over an unspecified period.
The home-equity loan appears, at this time, to be best suited to affluent people requiring substantial sums in predictable amounts over a medium term.
If tax revision eliminates the deduction for consumer interest payments, it would make sense to consolidate other types of loans into a home-equity loan. Yet that option is generally indicated only if the borrower is well qualified, can handle the balloon payment and intends to use it for some major expenditure.