Second mortgages represent the quickest, easiest route for many homeowners to turn their inflated real estate equities into spendable cash without selling their properties. Tens of thousands of homeowners are doing it across the country, making the multi-billion dollar equity loan field the fastest-growing segment of real estate finance.
But second loans also entail some significant risks to households who miscalculate their costs, and they pose challenges to the nation's economic managers who want to keep inflationary consumption under control.
A second mortgage that suddenly frees up $25,000 or $30,000 can provide a family's down payment for purchase of a lot and construction of a vacation home, the capital for acquisition of a sideline business franchise, or the dollars to convert an old, poorly-equipped kitchen into a gourmet cook's fantasy world.
But a second mortgage can also help bankrupt borrowers or send their property into a foreclosure sale by encouraging spending far beyond families' real incomes. The risk is greater with home equity loans than with many other forms of credit, Washington area mortgage brokers confirm, because some borrowers see their houses as an endless well, deepened every month by an economy that favors real estate over all other possessions.
Families who turn to second mortgages to consolidate their short-term, high-interest-rate installment debts -- an increasingly common use of home equity loans -- run the risk of going much deeper into debt, instead of solving their real money management problems.
Michael Lods, assistant vice president of First General Mortgage Co. of Rockville, an equity loan subsidiary of First Virginia Bank, said he is seeing an upturn in the number of over-extended households who use borrowed real estate equity dollars to create still more debt for consumer goods.
Lods said his own company's delinquency rate on second mortgages is about 1 percent, well below his estimate for the personal finance companies that are swarming into the equity loan field, but high enough to cause him concern about what might happen in a prolonged economic recession.
"The people I really worry about" Lods said, "are the ones who take $10,000 or $15,000 out of their homes to pay off all their 18 percent department store charges, credit card balances, car payments and the like but then turn around and start racking up new charge card credits the next week.
"If you've got $8,000 or $10,000 in short-term debts like that at high rates spread out among 10 different accounts, it can make sense to consolidate them, get rid of them, by borrowing on your house at 13 3/4 percent for 10 years.
"But if you start buying new furniture and boats and vacations on time right after you get a second mortgage that's costing you $350 a month on top of your first mortgage, then you're deeper in trouble than ever."
Many households don't calculate the recurring out-of-pocket expenses of second loans, said the head of one suburban Virginia mortgage brokerage firm who asked not to be named, "because they don't think of them as loans. They feel they've got money tied up in their houses, they've got an ace in the hole, and they're merely drawing it out."
The reality is, however, is that equity loans cost more, dollar for dollar, than first mortgages, and mean new debt on top of existing debt. The current squeeze in the nation's credit markets has pushed second-loan rates to historic highs of 16 to 18 percent -- or even more where usury rates permit them.
Loans for personal use in Maryland are at the 16 percent statutory maximum at many brokerage firms, and Virginia lenders are making only business or investment-related second loans at 16 to 18 percent, since the state's usury limit for consumer equity loans is 12 percent. p
Second mortgages are bonanzas for the lenders who make them, a fact that should put prospective borrowers on guard. In addition to interest rates that are 1 1/2 to 4 percentage points above prime first mortgage rates, equity loans from some companies carry service fees and other add-ons that push the effective interest rate to the borrower still higher.
For example, a common charge that many borrowers notice only when they want to pay off their loans early -- and most borrowers do, brokers say -- is a prepayment penalty that bumps up the effective annual cost of the loan by two or three percentage points. Some bank or S&L-related second mortgage lenders require no prepayment fees, but most of the smaller, unregulated second lenders tack them on loans to sweeten their returns.
Equity loans pose personal budgetary issues like these for individual consumers, but collectively they pose much more fundamental issues for the national economy. No federal agency or congressional committee has hard data on how many hundreds of millions of dollars in real estate equity are being pumped into the economy for consumption.
The impact on these loans on the economy as a whole over the past two years, however, has been to "monetize" huge amounts of paper profits from homeownership -- that is, to convert unrealized equity dollars into real dollars -- and direct them to the purchase of a wide variety of goods and services, from television sets to expensive cars, vacations and bigger homes.
To the extent these purchases have permitted the economy to expand despite towering interest rates in the capital markets, the nation's housing stock has been a key factor in forestalling the cyclical downturn that analysts have expected for the past year.
It could also help the economy bounce back from a recession by injecting funds rapidly for consumer purchases.
On the other hand, if the economy has relied excessively on inflated real estate equities to heat itself up when it should have been cooling down, the second mortgage boom could prove to be a factor contributing to a sharper, more dangerous recession.
If people reduce borrowings on their houses in the face of the new wave of interest rates, this could constrict an important supply of consumer purchasing power, and sharply cut sales of the goods, services and investments that have benefited from real estate equities. The heavy debt carried by equity loan borrowers could trigger serious delinquency and foreclosure problems if unemployment rates rise in a declining economy, jeopardizing the incomes necessary to support loan repayments.
No one knows which of these interpretations will prove correct. The odds strongly favor the long-term continuations of equity loans as a family financing tool, and the likely development of new techniques in this field, such as revolving "home equity account" lines of credit at your neighborhood bank.
But the dangers are there, both for individuals and the national economy, and can't be ignored.