Tough Times Series: A Closer Look at Home Equity Loans

by Dianne Molvig

A new kind of ATM appeared on streets across America in recent years—one equipped with windows and a doorbell.

To get cash to pay for whatever they wanted to buy, many homeowners tapped their home equity—that is, the value of their homes minus the mortgage amounts remaining due.

That was especially tempting during the go-go years of rising home values. Why wait to save to buy a plasma-screen TV or to take a Caribbean cruise when you had all that home equity just lying around, getting bigger and bigger?

Now that the economy has turned downward, some consumers are using their homes as cash machines in a different way. They're taking out money to pay for essentials, not extras. If they come up short to pay for living expenses, they use their home equity to cover the gap.

Owing more, owning less

As a result, American homeowners owe more than they own for the first time since the Federal Reserve began keeping such statistics in 1945. Homeowners' total equity slipped to 47.9% by year-end 2007, compared with 62% at the end of 1990.

Many homeowners now have maxed out their home equity borrowing and have no equity left to tap for future loans. Worse still, some are carrying more total debt on their homes than those homes are worth, if they're in a falling-value market.

"By some estimates, home prices already have fallen by 10% nationwide [since the peak market]," says Steve Rick, senior economist for the Credit Union National Association, Madison, Wis. "Some think prices could fall another 15% through 2009. So the amount of available equity to borrow against is drying up significantly."

Meanwhile, more borrowers are struggling to make payments on their home equity loans. The delinquency rate for fixed-rate home equity loans was 4.65% in the fourth quarter of 2007, up from 3.11% a year earlier, according to Moody's Economy.com, a ratings agency, and Equifax, a credit reporting agency. In the same period, delinquencies on home equity lines of credit nearly doubled, to 2.01% from 1.07%.

Expect more delinquencies to come, Rick says. "An increase in delinquencies on home equity loans occurred when the labor market still was relatively strong," he explains. "If the economy is going into a recession now, we'll see increased job layoffs. Unemployment will rise, payrolls will fall, and delinquencies will increase."

If you're maxed out

What should you do if you've borrowed as much as you can against your home equity? "The bottom line is you'll need to ride this out," says Fred Ryerse, senior vice president of lending at Members 1st Federal Credit Union, Mechanicsburg, Pa.

He emphasizes that real estate still is a good investment. "So if you can ride out periods when prices are declining or leveling off," he says, "you're going to be better off in the long run." In the meantime, he adds, "Make your loan payments and live within your means."

Those already having trouble making their home equity loan payments should talk to their lender, Ryerse says. "My message to people who are struggling: Don't hide. Call your lender. Let them know what's going on."

The lender might be able to work with you to find a solution. Speaking from the lender's perspective, "The last thing we want to do," Ryerse says, "is to foreclose on a property."

You might be able to work out a repayment plan or refinance your loan to make your payments more affordable. Another option could be a loan modification, in which the lender lowers the interest rate or stretches payments over more years to reduce monthly payments.

The "live within your means" part of Ryerse's advice is up to you. He notes, for example, that some people today use their home equity lines of credit to fill their gas tanks. Financing the purchase of consumable goods with home equity is "a sign you're not living within your means," Ryerse says.

To remedy this situation, you'll need to develop a budget and stick to it. A counselor at your credit union can help with budget planning. Simply put, you need to stop spending more than you earn. Resorting to other credit sources, such as credit cards, to replace home equity borrowing will lead to even deeper trouble.

"If you've maxed out your home equity," Rick notes, "your credit card rates probably are at something like 28%, too. Those are signs it really is time to change your standard of living a bit."

Smart borrowing

The key is to focus on investment, not consumption, Rick advises. "If you use your home equity to remodel your bathroom or kitchen, that's an investment. You'll get some payback. But if you're just taking out a home equity loan to pay for another trip to Mexico, there's no payback on that cash flow."

Ryerse echoes that advice. Using home equity for home improvements, financing a business, or your children's college education "provides long-term tangible value," he says.

Using home equity to consolidate debt can be another wise move—if you are disciplined. For instance, you could use a home equity loan to pay off higher-cost debt, such as credit cards. "Most consumer debt is at double-digit rates," Ryerse notes, "and it's at 20%-plus for some people. Home equity loans, especially at credit unions, have reasonable rates." You also may be able to take a tax deduction for the interest on a home equity loan, which you can't do for consumer loans. Ask a tax specialist for details.

But if you're using home equity to consolidate consumer debt, Ryerse advises keeping the loan term to five years or less. Otherwise, by stretching out the payments for many more years, you'll end up paying more interest overall. Another danger: Thinking that paying off those old debts gives you license to turn around and build up new ones.

Thus, using home equity to consolidate debts "is not necessarily a smart move for everybody," Ryerse advises. "If all you're doing is extending out the term or incurring new debt on the consumer side, that's not good."

Published June 23, 2008

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