Home-equity loans have become the cocaine of the financial world. They are the trendy way for American homeowners to keep up with the Joneses -- at the risk of an addiction that can be as disastrous as a craving for the expensive white powder that brings temporary nirvana.
The big trouble with home-equity loans is not just that they are so easy to get in an era when real estate inflation has given many homeowners a paper profit beyond their wildest dreams. The big trouble is that these loans -- if they are abused to the point where monthly payments can't be met -- may cause a wave of foreclosures that will rock the American economy.
Consider that Americans borrowed $27 billion by means of home-equity loans in the last three months of 1986, and will probably borrow an additional $125 billion this year. With more than $4 trillion in private housing equity nationwide, it seems likely that the market for home-equity loans has barely been tapped.
Have American consumers gone on a sudden buying binge? Not really. The fuel for the boom in home-equity loans was provided by the 1986 Tax Reform Act. The law phases out the deduction for interest payments on consumer loans -- except for interest on home loans. After 1990, taxpayers will no longer be able to deduct interest they pay on credit card balances, auto loans and other borrowing not backed by a mortgage on one's house.
But thanks to a truly revolutionary loophole, interest on home loans is still deductible -- even on new loans that use the equity in an existing home as collateral. And the loophole didn't limit home- equity loans to any particular purpose. As a result, these loans have been taken out for everything from medical bills to vacations in the Caribbean.
The banking industry was predictably quick to capitalize on the new version of an old form of credit. The bankers have enticed homeowners with low initial interest rates and disarmingly easy loan procedures.
In fact, the rule for home-equity loan applicants is a simple one: Buyer beware.
Two-thirds of the banks surveyed in one study said they demand full payment at a deferred date, while other lenders required only an interest payment during the loan term. Both set up a terrible crunch at the end of the term.
Few lenders offered fixed-rate loans, and 90 percent of the lending institutions refused to put a cap on the jump that interest rates could take in a year. These practices could throw millions of home-
equity borrowers into default practically overnight.
Another problem frequently cited by investigators is the "teaser rates" that lenders offer to lure borrowers, but which last only a few months and are superseded by ruinously higher interest rates.
The "red flags" that home-equity borrowers should watch out for include closing costs and annual "fees," which can be excessive and will add up over the life of the loan; taking the biggest possible "line of credit," which one may never use, but which could inflate closing costs and make the borrower appear overextended when applying for other credit; and the "payment shock" of a drastic rise in interest rates, which could send monthly payments ballooning out of control.