Peter Reed, vice president and head of consumer loans for the First National Bank of Chicago, has heard some out-of-the-ordinary reasons for taking out a home equity loan. But the strangest yet was to buy a racehorse.
”The borrower could definitely afford it, even if the horse lost,” Reed says, chuckling.
A home equity loan can come in various shapes and sizes. A home equity line of credit, generally referred to as a home equity loan, is a fixed amount of credit you draw against by writing special checks. With this type of loan, you pay only interest for the duration of the loan, usually five to seven years, then you pay off the loan with one balloon payment.
Another type is the more familiar second mortgage. Similar to a first mortgage in length, this type of loan requires regular monthly payments of principal and interest.
Whatever form the loan takes, it is most important to remember that it is secured by your home: If you fail to meet your minimum monthly obligation, you could lose your property.
Home equity loans are relative newcomers to the wide world of finance. Financial institutions began offering them in 1984 when the federal government started allowing tax deductions for interest paid on home equity loans of up to $100,000.
They began to gain strength and market share with the passage of the 1986 Tax Reform Act, which phased out personal interest deductions over five years. Only 10 percent of personal interest will be tax deductible in 1990, the final year of the phaseout. Personal interest will not be deductible in 1991.
Home equity loans remain fully deductible, although that, too, could change. Congress has considered limiting the deductions on home loan interest as part of its deficit-cutting strategy, although no firm proposals have been made.
”The whole purpose of the home equity loan is that it is deductible to the same level as mortgage interest,” says Phil Ravid, partner with the Chicago-based accounting firm of Ravid & Bernstein. ”That`s why all the banks are pushing it.”
There are plenty of takers. According to recent government figures, American homeowners have accumulated nearly $4.5 trillion in home equity through repayment of their mortgages and appreciation of property values.
In January, Shearson Lehman Mortgage Corp. approved $48.7 million in home equity lines of credit. Reed says that First Chicago had only $25 million in home equity loans on the books in early 1986. Now the amount exceeds $500 million.
There are almost no restrictions on the use of home equity loans. That means you can use the money to pay your taxes, buy a car or even buy a racehorse. But it is illegal to pay off a first mortgage with a home equity line of credit.
”Four times a year we take a look at the checks, and their destinations truly vary by season,” Reed says.
”At tax times, the preponderance of checks go to pay taxes. In September they go to pay tuition, and occasionally you`ll see a check made out to a car dealership.”
Peter Soraparu, of Arlington Heights, says he has been drawing on his $25,000 line of credit for about 1 1/2 years.
”It`s an attractive option for me. We`ve used it principally to finance improvements around the house, stuff we would have had to pay cash for or not do at all. I think we`ve enhanced the value of the house as well.”
Soraparu says he did extensive work on his family room, including the addition of a bay window, a woodburning fireplace and other improvements. He also upgraded his kitchen.
”We`ve used the money solely for home improvement because I haven`t had the need to use it for anything else.
”But,” he says, sounding more than a bit like a home equity commercial, ”it`s there if I do.”
The outer limits
There are limits, however, on the amount of money your lending institution will allow you to borrow.
According to Delois Davidson, a consumer loan officer in LaSalle National Bank`s home equity department, the bank will lend up to 75 percent of your equity minus any debt, such as a first or second mortgage.
Reed says that First Chicago also uses the 75 percent figure but looks at the borrower`s debt-to-income ratio, too. That figure compares the total amount of debt the potential borrower has accumulated, including car loans and first mortgages, and compares it to the borrower`s salary.
Looking at the debt-to-income ratio helps a loan officer determine if a home equity loan on top of the borrower`s other debt will be an overwhelming addition to his or her monthly expenses, Reed says.
”We use a 36 percent debt-to-income ratio. And if we feel the individual can`t afford it, we won`t grant the loan.”
Reed uses a rather simple formula to figure out how much new debt a borrower can afford: He multiplies the borrower`s gross monthly salary by 36 percent, then subtracts the borrower`s current debt to determine the new debt he or she can can assume comfortably.
”If 36 percent of your monthly income is $1,440, and you already have $1,000 in debt, you can comfortably afford to pay $440 in new interest payments,” he says.
At the bank`s current rates, a monthly payment of $440 would support about $35,000 of home equity debt.
A 3-tiered system
Though most lending institutions will underwrite a home equity line of credit or second mortgage for no more than 75 percent of home equity, Shearson Lehman Mortgage Corp., based in Newport Beach, Calif., has a staggered loan-to-value structure, which depends on the property`s value.
Its program, known as Prime Only because the charge is the commercial prime interest rate, will authorize a line of credit up to 80 percent of the equity for homes whose appraised value is $500,000 or less, 75 percent for homes valued from $500,001 to $850,000 and 70 percent for homes valued at more than $850,000.
There is at least one drawback to Prime Only: The minimum line of credit that can be established is $35,000. In other words, one would have at least $43,750 worth of equity in a home to qualify.
Ravid stresses that you have to get down and dirty with numbers when comparing a loan with higher interest rates and nominal costs to one that charges points (each point being equal to 1 percent of the loan) and fees but a lower interest rate.
”You want a very good interest rate, but you also want a good institution,” Davidson says.
You also have to decide what loan term you would like. Most lines of credit run for five to seven years, but the Prime Only program is 30 years long, more like a first mortgage. But you can write checks against the line of credit for only the first 10 years, loan consultant Steve Gustavus says.
After 10 years, the line of credit converts to a regular second mortgage. In other words, after 10 years you no longer can borrow against the amount even if you still have money left in the loan, and you start paying back the loan with regular principal and interest monthly payments.
”You pay interest only for the first 10 years,” Gustavus says. ”Then the loan becomes like a 20-year fully amortized loan that floats at prime.”
One problem with floating loans pegged to the commercial prime rate is that they go up and down with the cycle of the economy, Ravid says. ”You have to be careful. In the last 10 years we have seen interest rates as high as 18 percent.”
Most lending institutions cap the floating interest rate at 21 percent, but a Prime Only line of credit can be charged an interest rate of up to 25 percent.
The end result
”Home equity loans are frightening things because . . . nobody talks about repaying the principal,” Ravid says. ”When the loan comes due you have to either refinance or come up with the money. Eventually something`s got to give.”
Both Reed and Davidson say their banks have begun to talk about what will happen when the seven-year-old loans begin to come due in 1991.
”We`ll do one of a number of things,” Reed says. ”If the borrower has been paying us back interest as agreed and we`re all happy, we`ll simply rewrite the loan for another seven years. Or if the borrower feels like he wants to quit using the line, we would write the amount into a fixed-rate home equity loan with regular payments of interest and principal.”
Still, Ravid cautions borrowers against running out and using their home`s equity to finance a lot of purchases.
”If you`re paying 10 percent for a home equity loan but you can get a car loan from a dealer for 3 to 4 percent, after tax that car loan may only be around 7 or 8 percent,” he says. ”And it`s cheaper than your line of credit.”
