At the moment, home equity loans are cheap, easy to get, and, best of all, tax deductible. But consumer groups warn that overeager lenders may be luring homeowners into a trap. These loans - a line of credit to borrow against the money one has in his or her house - are ``land mines that could be triggered by income loss, higher interest rates, or a large balloon payment,'' says Stephen Brobeck, executive director of the Consumer Federation of America. Over the next few years, he says, many people may lose their homes as a result.
The issue is becoming more worrisome as the prime rate rises, as it did again on Friday. Most home equity loans are pegged to the prime rate, so any uptick raises monthly payments for thousands of people - though a drop often won't mean a lower payment.
Home equity loans, which have been around in one form or another since 1975, got new luster last fall. The new tax law phased out tax breaks for almost all other types of consumer borrowing. Now home equity loans are selling like hotcakes. Perk Lodge of the National Second Mortgage Association figures the amount borrowed through home equity loans will double this year to $70 billion from $35 billion at the end of 1986.
Last week the Consumer Federation of America and Consumers Union released a survey of financial institutions offering home equity loans. The groups claim institutions use deceptive or incomplete advertising that can persuade customers to get in over their heads.
Others disagree. ``I don't see that banks are going overboard in pushing home equity loans,'' says Thomas J. Hauschild, tax manager at Coopers & Lybrand's Minneapolis office. ``The danger is in consumer spending in general rather than one specific type of loan.''
Still, someone who is likely to move should think twice before taking out such a loan, says Mr. Hauschild. He uses this example. Say you bought a house for $100,000 and have $40,000 in equity. You decide to buy a $35,000 boat, and open a home equity line of credit. Now your equity in your home is $5,000. ``If you're transferred, after paying closing costs, you have practically nothing left to use as a down payment for your next home,'' he says.
Institutions generally call in the loan when the house is sold. Thus the whole amount of the home equity loan would be due, creating a balloon payment. And if it is a forced sale, you might not be able to pay off the first mortgage and the equity loan. The bank could foreclose.
Homeowners with adjustable rate mortgages (ARMs) on their first mortgage face another problem. Since most equity loans are pegged to either Treasury bills or the prime rate, a rise in interest rates would result in a ``double rate shock,'' says Robert Hobbs of the National Consumer Law Center. ARMs generally limit the amount the rate can rise (usually 2 percentage points a year, 5 points over the life of the loan). But most equity loans do not have caps.
Other things to watch:
``Teaser rates.'' Many banks offer a low introductory rate - ranging from 3.9 percent to 8.7 percent - but then raise it (generally to two points above the prime) within a few weeks. For example, Mellon Bank offers a 5.9 percent rate, but then it jumps to 4 points above the Treasury bill rate (making it about 11.6 percent today). Then the low monthly payments evaporate.
Up-front or annual fees. Say you want to buy a car. You can use a home equity loan, and interest payments may be deductible, unlike an auto loan. But you have to pay closing costs - for a title search, appraisal of the house, etc. - that you don't pay with an auto loan. Citicorp Savings in Washington, D.C., charges a $250 non-refundable application fee, and other closing costs are about $400. According to the CFA survey, annual fees ranged from $15 to $100. Most such fees were not advertised.
Interest-only payments. These are great from a tax standpoint but can mean sudden balloon payment of principal when the loan comes due. Or they can drag out the loan for years, leaving borrowers ``indentured to their banks,'' says Michelle Meier at the Consumers Union.
Consumer groups want Congress to regulate home equity loans, but that's unlikely to happen anytime soon. Christopher Dodd (D) of Connecticut, chairman of the Consumer Affairs subcommittee of the Senate Banking Committee, is ``concerned about the potential implications'' of home equity loans, says an aide, ``but we're not drafting legislation.''
Meanwhile, many are convinced that competition will iron out the wrinkles.
``Consumers wouldn't buy uncapped ARMs,'' notes Mr. Hobbs at the National Consumer Law Center. So banks put a cap on the amount they could raise their rates without federal legislation. The same is likely to happen with home equity loans, he says, ``unless we have a recession first.'' Then enough people might be distressed that Congress would act.