Tools for Creating the Life You Want!
When Mining Your Home for Money, Beware of Fool's Gold
by Marc Eisenson & Nancy Castleman
It used to be that you actually needed some home equity to qualify for a home equity loan. Not so anymore. Every place you turn, there’s a lender encouraging you to consolidate your debts and solve your credit problems by borrowing against your home, sometimes for more than it’s worth.
Used wisely, home equity loans can be a relatively low-cost way to borrow money for big expenses such as college tuition. And even though these loans aren’t the bargain they once were -- thanks to rising interest rates -- they can still beat 18% credit card rates by a mile.
What’s more, if the amount you borrow doesn’t exceed the fair market value of your home (or up to $100,000 for a couple), there may be some extra tax deductions as well. So it should come as no surprise that home equity loans are more popular than ever, particularly as a way to consolidate debt. In fact, debt consolidation is the biggest single reason people give for why they’re taking out a home equity loan.
So what’s the problem?
The problem is that after they’ve put their homes on the line, all too many folks continue overspending. Before long, they’re in deeper credit trouble than before. Making matters worse, more and more mortgage companies are using “predatory lending” practices to get people to sign on for high-rate loans, which come with excessively high fees, that often push homeowners toward foreclosure. Fortunately, the powers-that-be in and around the Beltway are waking up. While there are currently laws on the books that protect home equity borrowers to some degree, there’s been an outcry lately for more legislation and regulations to protect consumers who apply for home loans. It’s likely that this issue will be a hot one in the coming year.
Meanwhile, organizations like Fannie Mae and Freddie Mac are doing what they can -- adopting guidelines to screen out these predatory loans from the mortgages they buy from lenders and re-package for sale to investors. Still, unwary homeowners looking for a loan -- especially those with poor credit histories who live in low-income neighborhoods -- remain fair game.
Don’t want to fall victim to some predator … ahem … lender? We’ll help you sort out your home equity options, and alert you to the dangers that lurk in the fine print.
Stripping, flipping, and other home equity hazards
There are plenty of reputable lenders to choose from if you’re going for a standard home equity loan, and your credit is top-notch. The offerings are less appealing – and are sometimes downright fraudulent – for those whose credit picture isn’t so rosy. You’d never know it, though, from the sales pitches thrown by those baseball has-beens and other home equity hucksters – via TV ads, direct mail, and the Internet. The outfits they represent, which are known as sub prime or nonprime lenders, have become big financial players, accounting for some $240 billion in home equity loans.
Think they’re all sleazy fly-by-nights? BusinessWeek reports that top Wall Street firms, including Lehman Brothers, Merrill Lynch, and Salomon Smith Barney, underwrote some $60 billion of these sub prime loans in 1999, alone.
At a minimum, borrowers with damaged credit or unsteady income tend to pay a good deal more in interest and fees than those with top-rated credit. Sub-prime lenders are loathe to reveal outright how high the costs can go, but we’ve heard of interest rates from 18% to 23% and closing costs of as much as $5,000 on a $25,000 loan!
Worse still, some predatory lenders – and other finance companies – have dreamt up a variety of pretty sleazy practices. For example:
Equity stripping -- A lender encourages you to inflate your income on an application, knowing you probably won’t be able to keep up your payments. Guess who gets the house when it’s foreclosure time? Yup, the lender that told you to fudge the figures.
Loan flipping -- A lender talks you into “flipping” your existing mortgage loan into a bigger, longer term loan so you can “take the vacation of your dreams” or “add that new bedroom.” Who cashes in on all the extra interest and fees you’ll now owe? The new lender, of course.
125% borrowing -- These relatively new offerings lend you more than your house is worth -- up to 125% of its value. Even if you can make the payments, watch out! What’ll happen if you get transferred and have to move? The odds of you being able to sell your home for its current market value are high enough in these turbulent economic times. Who can count on getting 125% of their home’s value? And if you lose your job, what then?
If we haven’t already put the kibosh on 125% loans for you, consider this: You cannot get a tax deduction on any part of a home equity loan that exceeds the fair market value of your home. The IRS has said it’s monitoring the 125% loans very carefully to make sure that homeowners aren’t incorrectly trying to write off too much interest.
More Predatory Practices
“Home improvement” loan cahooting – This abusive practice involves lenders who are, you guessed it, in cahoots with less than honorable contractors. The homeowner is approached with a good deal on a major home improvement, say a new roof. The oh-so-helpful contractor offers to arrange a loan for the project. Along the way, some papers get signed, which turn out to be for a home equity loan -- with a high interest rate and fees. If the homeowner eventually catches on and balks, the contractor, who may already have been paid by the lender, and might not care about completing the job, could leave the work unfinished.
Even a perfectly legitimate home improvement loan can leave you poorer. Real estate expert Joseph Cummins, author of Not One Dollar More. How to Save $3,000 to $30,000 Buying Your Next Home, offers these cautionary words to people preparing to sell their homes:
“Think hard before taking a HELOC because you believe ‘modernizing’ (like putting in a new kitchen) will pay you back with a correspondingly higher selling price. Chances are it won’t! The costs of such renovations are rarely recovered in a higher selling price.” Instead, Cummins advises that you “freshen up, clean up, and clear out the junk. These ‘investments’ will definitely repay you.”
Packing and other last minute surprises -- Unsavory lenders sometimes spring surprises at the closing. Just before you sign, you may notice charges for “credit insurance” and assorted other hidden fees -- a practice known as “packing.”
Or when you read the agreement, you find that the interest rate is higher than what you were promised. Sure you can complain and refuse to sign. But the lender is hoping that because you need the money quickly, you’ll go along with the deal anyway. And if you question fees or rates, some sleazy loan salespeople will simply mislead you about the actual charges.
That was one of the allegations brought by homeowners who had borrowed from First Alliance Corporation, a sub-prime lender underwritten by Lehman Brothers. As reported by “20/20,” some First Alliance customers wound up paying more than 20% in loan origination fees, with a steadily rising interest rate -- not at all what they’d been told. (The lawsuits subsequently pushed First Alliance
According to the National Home Equity Mortgage Association (NHEMA), there are just a “handful of unethical operators” in the industry. NHEMA now asks its members -- some 300 lenders who make 80% of the nonprime home equity loans -- to follow a set of “Best Practices.” These guidelines include drafting documents in simple and clear language, accurately disclosing costs, and taking into consideration whether a borrower can actually repay the loan.
We find it a little disconcerting, though, that the guidelines are prefaced with the following statement: “NHEMA’s membership is quite diverse and varies in size and product offering. Therefore, the modification of or failure to adopt one or more of these voluntary guidelines shall not necessarily be taken to indicate that the lender has violated any law, duty or standard of care.” Hmmm.
Words to Deceive -- Less Obvious Traps to Avoid
“Low, low monthly payments.” Finance companies that charge very high rates – 23%, for example – try to lure customers with ads that focus on the monthly payment. Don’t fall for this expensive trap! You’ll end up in hock for decades, paying far too much interest.
Low introductory rates. Watch out for a great teaser rate that jumps up after 6 months to a year. A short-term bargain could turn out to be very expensive in the long run.
Hocking the farm for your next set of wheels. Home equity loans are often touted as an easy, tax-advantaged way to finance a car. Be careful! The tax benefits are often highly overrated, and if you can’t meet the payments, you could lose your house, to say nothing of your car.
Since home equity loans typically have such long terms (10 or 15 years), even if the interest rate is lower, unless you pre-pay -- that is, send in more than the required amount -- your debt could easily outlive your car and dramatically increase its cost. But if you know you trust yourself to manage your debts, and if you’ll have enough deductions to itemize them on your taxes, a home equity loan might save you money on your next car. To guarantee that it does, plan to pay the loan off fast, say in no more than three years or 25,000 miles.
Balloons. Some home equity loans start with “interest-only” payments being required, say, for five years. If you’re having trouble meeting your current obligations, a loan like this is very appealing, because it’s much more affordable in the short-term. But if interest payments are all you send in for those 60 months, you won’t lower the outstanding principal by a penny. Then all of a sudden, your payments will go way up, because you’ll have to start paying back the principal, too. Times may have improved for you by then. but maybe they won’t.
Before You Sign -- An Ounce of Prevention
There are a variety of ways to protect yourself from home equity scams. First and foremost, remember that you’re putting your home on the line. Don’t be pressured into signing any document. Run, don’t walk, when a lender tells you to put false information on a loan document or asks you to sign blank forms that s/he’ll “fill in later.” Also beware of loans that impose a prepayment penalty.
If you have second thoughts after signing a loan agreement, know that you have three business days to cancel the contract – no matter what the lender tells you. And once you have an ongoing loan, look at the statement every month and keep careful records. Some unscrupulous lenders tack on fees or claim you haven’t kept up your insurance payments … so they can stick you with more costly insurance.
If you’re considering a high-rate or high-fee loan, you have some additional rights under the Home Ownership and Equity Protection Act. (HOEPA) (As of this are writing, HOEPA’s definition of high rates and fees translates to loans that are in the neighborhood of 16.30% and above, and fees that are more than $451.)
This law forbids lenders from making loans without considering if the homeowner will be able to repay it. They cannot make payments directly to home improvement contractors or require balloon payments in less than five years. While HOEPA protects you against some of the more egregious practices of predatory lenders, it can’t protect you against the cost. As the FTC cautions: “These loans are extremely expensive ways to get money. You could lose your home if you can’t make the payments.”
Home Equity Loan Guidelines -- How to save money on your home equity loans
Compare and contrast. As with any home loan, you’ll save money if you take the time to compare the interest rates and fees charged by a number of banks, as well as credit unions and mortgage brokers. Keith Gumbinger, vice president of HSH Associates (financial publishers who track mortgage rates), recommends that homeowners check the offerings of at least a dozen local lenders, if possible. “Leave no stone unturned,” he advises.
Play with the formula. If you’re considering a HELOC, find out how the lenders charge interest. Rates may be tiered based on your “loan to value ratio” -- the more debt you’re carrying the higher the rate. If you can lower that ratio by borrowing a little less, you might find yourself in a more favorable bracket, and get charged a lower interest rate. You can also check into getting a fixed-rate HELOC, though these aren’t widely available.
Use the hometown advantage. Some of the best deals come from small, local banks. “The big guys spend lots of money on marketing,” Gumbinger explains, and homeowners pay for it through higher rates. “The little guys compete with better pricing.” For example, in a week when the average rates nationally were 9.30% for home equity loans and 8.51% for HELOCs, rates at American Savings Bank in Connecticut started at 7.25% for short-term home equity loans and 8% for 10-year credit lines.
Cut closing costs. While you’re rate shopping, be sure to ask which closing costs can be waived and which ones can be negotiated.
Ask for special deals. Some banks will cut the interest rate if you keep all your accounts there, or have payments automatically deducted.
Get the right type. Be sure you’re applying for the right kind of loan. For example, if you’re doing a series of home improvements over a period of time, Gumbinger points out that you might be better off with a credit line rather than a traditional loan. Otherwise, you’ll start paying interest right away on money you won’t be spending for upwards of a year, maybe two. (For more of HSH’s sound advice, order the informative booklet, Home Equity: A Consumer’s Guide to Loans and Lines.
Create a pre-payment plan. Even if you get the best rate on a 100% legit home equity loan, and even if you can get every tax break imaginable, you’re going to end up paying a pretty penny by the time 10 or 15 years have gone by. Fortunately, it’s easy to cut the loan’s cost -- by pre-paying enough to pay it off in three or five years, for example, instead of a decade or more. See the table below, which shows how much to send in every month on loans of $5,000, $10,000, and $15,000.
Pay off your home equity loans as fast as you can
The cost of a 9% home equity loan if paid off in 3, 5, 10 or 15 years.