The new homeowner must-have: a home equity line of credit.
At least that’s what lenders pitching them in come-on letters and cold calls are saying — especially to Texans, who just got legislative permission to use these loans 18 months ago.
Home equity lines of credit can be helpful if done for the right reason and handled with the right amount of discipline. But they also can be treacherous for the person looking for a quick buck.
First, some background: For those who have not received the letters or calls, equity is the dollar amount difference between what you owe on your home and its current market value.
If you own your home free and clear, you have 100 percent equity. If you sold the house tomorrow, you’d get to keep all the proceeds except what you might owe in taxes. But if you have a loan for, say, $200,000 on a home that appraises for $300,000, then you have $100,000 equity in your home.
If you sold the house tomorrow for the appraised value, you would keep one-third of the sales price minus any taxes owed, and the lender would get two-thirds.
Home equity lending lets you use that equity without having to sell the house.
So, if you take out a home equity loan, you get a lump sum of cash that’s borrowed at a fixed interest rate.
With a home equity line of credit, the bank lets you borrow a certain amount whenever you need it during a 10-year period. The interest rate is variable.
It helps to think of the loan as something you take for immediate needs and the credit line as something you may use for future needs.
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Another difference: Interest rates for the loans are higher than credit line rates. In Houston, equity loans are averaging about 7 percent for loans of $50,000 or more and 8 percent for smaller ones, said Marisa Thomas, home equity sales manager for Chase Bank and Bank One in Houston.
The average rate for the credit lines is the prime rate — the interest rate banks charge their most creditworthy customers. Since Feb. 2, the prime rate has sat at 5.5 percent but it could go up today, when Federal Reserve and its Chairman Alan Greenspan meet to discuss lending rates.
Another big difference is that homeowners tend to get approved for more money through a credit line than with a loan.
Those differences in rates, terms and flexibility have made credit lines the “it” financial tool. Bankers and financial planners alike are suggesting to clients that one of the first things they should do is set up a credit line for “just in case.”
And that’s worrisome.
The first piece of financial advice used to be to put away three months of salary in a savings account and call it an emergency fund. Use the money in the account to cover the bills if you ever got hit with an uninsured medical bill, a job loss or other major financial catastrophes.
Now the guidance is to use your home’s equity as the emergency fund instead.
“It used to be that if you had to take a second mortgage, you had hit hard times,” Thomas said. “Now it’s a smart way to leverage your debt if you use it correctly.”
Note that word “correctly.”
The logic that taking on debt will leave you in a better financial place only tracks if you practice discipline. And, right now, many Americans are not displaying a familiarity with that skill.
The nation’s savings rate is at an atrocious level, nearly zero percent. Only about half of the nation’s households are saving money in tax-advantaged retirement accounts, such as 401(k)s, 403(b)s and IRAs.
And now consumers may have to deal with new rules that will make it tougher to qualify for personal bankruptcy protection.
Those tighter bankruptcy rules, which passed the Senate and appear to have a clear course in the House, should make home equity lenders and consumers both examine track records of financial self-restraint.
The proposed legislation makes it harder to file for personal bankruptcy through Chapter 7 of the Federal Bankruptcy Code, which allows individuals and businesses to walk away from unsecured debts not backed by homes, cars and other tangible assets.
That will push more people to take Chapter 13 bankruptcy, which requires debtors to make great restitution to creditors.
“The general statistic is about 66 percent of the Chapter 13 cases fail,” meaning they never repay the full amount determined by the court, said Karen Gross, president of the Coalition for Consumer Bankruptcy Debtor Education.
Yet, many manage to repay their mortgages before they fail. Gross expects fewer will do so if the bill passes.
The reason is that a provision of the bill allows lenders to collect the full amount of what’s owed on the loan instead of just the current market value of the collateral backing the loan.
That could make the debt repayment more costly to those seeking bankruptcy protection.
That — and the rising interest rate environment putting pressure on adjustable rate mortgages — could result in more mortgage defaults.
And people whose retirement savings plans include selling a home and combining the profit with Social Security checks need to control as much of their home’s equity as they can.
So, if using home equity sounds like a good way to pay for a vacation, stop thinking about getting a credit line. You don’t have the discipline to use it wisely.
But if setback after setback has prevented you from saving money and investing in mutual funds, and you don’t carry credit card balances, then you might consider a credit line to get cash — if you need to make improvements on your home.
“Debt is an addiction in this country,” says Les Vicain, owner of the Financial Solutions Firm in Houston and a member of the Financial Planning Association of Houston. “If they have any extra credit sitting around, most people will go out and use it.”
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