If Congress wants evidence about how federal tax policy can transform consumer behavior, it need look no further than a forthcoming report on the state of the American home equity loan.
Thirty years ago second mortgages were considered a backwater of consumer credit, aimed primarily at people who had no other way to raise cash. Today, though, they are a product for the creme de la creme: Home equity borrowers have higher incomes than the average American household, they pay much less for their credit than people who take out ordinary consumer loans, and they default on their obligations at a very low rate.
A statistical blip on most bankers' screens as recently as the late 1970s, home equity loans now account for more than $176 billion in household debt held by the 100 largest commercial banks that offer them. They represent an astounding 64 percent of all consumer credit at the banks that participated in the 1999 home equity study, scheduled for publication in December by the Consumer Bankers Association, a national trade group.
A key to this transformation: the 1986 Tax Reform Act, which eliminated the tax deductibility of interest payments on all consumer borrowings--such as auto loans, credit cards and charge accounts--but retained it for home equity-related borrowing.
The effect of the change was to radically reprice American consumers' debt options in favor of home-secured borrowings. And consumers got the message, loud and clear. No wonder the study found that the outstanding dollar amounts of home equity loans and credit lines now exceed any other type of consumer loan product on the books of participating member banks by a ratio of 4 to 1.
You don't have to be a math genius to figure out why. If you own a home and want to finance a new car, you might have the choice of an auto loan at 10 percent or an equity credit line carrying a current rate of 8.5 percent. Not only is the interest rate on the equity line lower, it's tax-deductible--effectively reducing the rate for many people to less than 7 percent.
Just who are the typical home equity loan borrowers of 1999? According to the forthcoming study, most are 35 to 49 years old, although 12 percent of them are 20 to 34 years old. They have average household incomes of about $65,000, well above the national average. They are stable, solid citizens: They've owned a home for about 10 years, and they've held their current job for seven years. Their homes are worth about $170,000, their first mortgage balances average $85,411, their home equity loan balances work out to $37,627, and they've got an extra cushion of $46,585 in home equity, thanks to appreciation in the value of their houses.
Most borrowers take out home equity loans or credit lines to pay off other, higher-cost debts, such as credit card balances and revolving charge accounts. Fully 48 percent of equity loan borrowers and 39 percent of equity credit line borrowers say debt consolidation was their principal purpose in obtaining the funds.
Home improvement projects are the next largest use of equity credit, followed by automobile purchases, education and large consumer purchases. An emerging trend among homeowners using equity credit lines is to finance a variety of miscellaneous personal expenses with their homes. Nearly one-quarter of equity line drawdowns now go for vacations, household expenses, and medical and business costs, as well as investments.
Home equity borrowers also tend to be dependable customers, compared with borrowers who take out regular consumer loans. Only 1.3 percent of equity loans at the banks in the new study were delinquent by 30 days or more. Other consumer borrowers were delinquent at a rate 30 percent higher.
Most home equity lines carry adjustable rates, with changes made monthly or quarterly, as measured against a national index such as the prime rate. Significantly, as competition among banks for equity-line customers with the best credit quality has increased in recent years, the effective cost of equity borrowings has actually decreased. Whereas in 1992, according to the study, the typical credit line carried a rate set 1.75 percentage points above the index rate, in 1999 the median "spread" was just 1 point above the index.
Does all this mean that home equity debt has become "smart" consumer debt, and that homeowners should hock their property to the hilt? Hardly. Home equity debt is cheaper than other consumer credit alternatives, and it's tax-subsidized to boot. But never forget its most sobering drawback: Fail to pay off your home equity line, and that once-friendly banker can foreclose on your house and put you out on the street. He can't do that if you stiff him on your credit cards.