Home Truths about Equity Loans

If the housing market sags, tapping a home's value for cash can mean big trouble for borrower and lender -- even the guy down the block

By Amey Stone

When cash gets tight, tapping into the equity you've built up in your home can be a great way to come up with extra money. You've got several choices: You can refinance your mortgage, taking out a new loan for more than you need to pay off the old loan, and pocket the difference (this is known as "cash out" refinancing). Or, if your first mortgage is at a nice low rate, you can either take out a shorter-term home-equity loan (essentially a second mortgage), or sign up for a home-equity line of credit that you can tap should the need arise.

All three options offer ready cash at interest rates that are now near historic lows, plus the opportunity to deduct the interest portion of the payments from your income tax. Homeowners are taking advantage of these loans in droves. But there's a reason why equity in your home provides a cheap and readily available source of credit -- you're putting your home up as collateral. "With unsecured debt, the worst that can happen is that you declare bankruptcy and have a black mark on your credit report," says Daniel Ray, editor-in-chief of loan data site Bankrate.com. "Do that with a home-equity loan and you lose your house."

A certain amount of debt is a practical necessity for most families. As for the most recent boom in cash-out refinancings and home-equity borrowing, "On the whole it's a good thing, since people usually make this decision in a reasonably well-informed way," says Robert Van Order, chief economist at Freddie Mac.

CHUNK OF CASH.

  Thanks to rising home prices, a lot of people have equity to tap if they so desire. Given lower mortgage rates (the 30-year fixed now averages 6.94%, the fourth week in a row below 7%), many people can take out a nice chunk of cash without increasing their monthly payments.

Freddie Mac reported in late August that 57% of the loans refinanced in the second quarter took 5% or more of the equity out of their homes. In the first quarter, only 52% of loans were the cash-out kind. "Cash-out refis have been a huge part of the mortgage boom," says Ray Mark Zandi, chief economist at Economy.com, who estimates that a record $33 billion was injected into the economy in the first half from cash-out refinancing.

Home-equity loans, which have grown a lot cheaper thanks to falling rates, are also running very strong this year. The average rate on a $10,000 home-equity line of credit is now 6.85% and, for a $10,000 home-equity loan, 8.90%, according to Bankrate.com. Home-equity loans in the first part of the year put $15 billion in consumers' pockets, estimates Zandi.

"RED FLAG."

  What worries economist Robert Smith, president of Smith Affiliated Capital, is the high and fast-growing rate of delinquencies among Federal Housing Administration loans, which are often issued to first-time borrowers. That figure is up to 10.79%, an increase of close to a percentage point, vs. an increase of less than a quarter-point for conventional loans, according to the Mortgage Bankers Association of America. Says Smith: "That could be a red flag" that some consumers are starting to slip into real financial trouble. He notes Smith that "your mortgage is the last thing you want to be late on."

The rate of foreclosures, although a low 0.68% in the second quarter, is also ticking up. Van Order expects that figure to rise, in part because it has been so low over the past two years. But he acknowledges that the less equity a person has in a home, the more likely that individual is to default. And right now, while home ownership is at a record high, the percentage of equity that owners have is at an all-time low, according to Federal Reserve figures.

Clearly, there's a broader economic impact to all this. On the bright side, the refinancing and home-equity lending activity gives consumers more money, helping keep the economy afloat. "Without that cash, consumers would've probably pulled back more significantly, and the economy would almost certainly be in recession," Zandi says.

ONE-HIT WONDER.

 By borrowing against their homes, however, many people are now more vulnerable to a weakening economy. In hard-hit regions, layoffs can mean an increase in foreclosures, which drives down home prices. Then, everyone suddenly feels a lot poorer, so people rein in their spending.

Some of the most often stated reasons for taking out a loan, such as consolidating higher-interest debt or investing in home improvements, can backfire (see ). And, if you deflate the financial cushion you've built up, you won't have the option of doing it again. The number of people falling behind on their payments has recently hit a high. For the second quarter, 4.63% of outstanding mortgages were at least 30 days late, according to the MBA. The last time it was near this high -- 4.6% -- was in the third quarter of 1992, just as the economy was struggling to come out of back-to-back recessions, notes Moody's.

Things could get even worse if homeowners in regions bearing the brunt of the slowdown find they owe more on their homes than the homes are worth. Then foreclosures may really spike. Lenders could then get in trouble and clamp down on loans -- causing a credit crunch that makes everything worse.

OPTIMISTIC.

  Most economists, however, don't worry about the worst-case scenario. In fact, they're eager to see continued consumer spending. "I'm not overly concerned about it now," says Zandi, who expects the economy to be in better shape a year from now. Says Van Order: "A lot depends on what happens to home prices." He notes that, overall, they're still rising -- even though in some pockets, such as around San Francisco, they may be coming down.

As the economy shows few signs of picking up, you might want to preserve home equity in case your financial situation worsens. Tapping equity makes the most sense to pay for relatively short-term hits, such as college tuition or health-care bills, rather than to fund a lifestyle that in a slowing economy you can no longer afford.

You might want to tap your home equity to:   But here's how it can backfire:
 
Consolidate debt: Rates are much lower than credit-card debt. Plus, you get to deduct the interest   Most people just run up their credit cards again and end up deeper in debt a year later. If you do this, tear up your cards
 
Invest in home improvements: A new kitchen or bath can raise the value of your home. So effectively, you put the equity back in again   Most improvements don't increase value by as much as they cost. If home prices fall, you may end up owing more than your house is worth
 
Buy stocks: With the aftertax cost of a home-equity loan only about 6%, you might figure you can do better than that in the stock market   Maybe so, as long as you have a long time to wait. But if the stock market continues to slide near-term, you'll be kicking yourself for losing that money
 
Create an emergency fund: If your savings have dwindled, you might feel a lot more comfortable with cash on the sidelines   Are you sure you won't spend it on nonemergencies? Create such a fund now, and that money might not be there when you really need it

Stone is an associate editor of BusinessWeek Online

Edited by Beth Belton