When Congress passed tax reform, the bankers saw a moneymaker in home equity loans. And even though thousands of Americans did tap the equity in their homes, the banks and savings-and-loans felt they could get more people to sign up if the loan products were designed right. After a little adjustment here and a few modifications there, the lenders do seem to be improving their home equity products to make them more attractive and, in some cases, fairer to the customer.
The changes come amid calls for tough new consumer protection laws, prompted by reports of people taking on more debt than they can handle and a lack of full disclosure of all the terms of these loans.
The most significant change will put some limits on how high home equity payments can go. A major drawback of most of these loans has been the lack of interest rate ``caps.'' While today's rates may be attractive, partly because interest rates in general are fairly low, the adjustable rates on home equity loans are tied to a broad index, like three-month Treasury bills or the prime rate. If these go up - no matter how high - so do your monthly payments. Without the kind of cap used on most adjustable-rate first mortgages, your equity-loan payments could go through the roof.
To keep the payments manageable, a few banks are offering home equity loans with guaranteed rate caps. Bank of New York, for example, guarantees that the rate on its EquityLink credit line will not increase more than 2.86 percent over the first five years of the loan. The initial rate is 1.4 percent over prime, which currently puts it at 9.65 percent. The guarantee means that the rate would never exceed 12.5 percent, says bank spokesman Scott Peterson.
``One of the things people cite when they've criticized these loans was the lack of an interest rate cap,'' Mr. Peterson says. ``We think this will deal with that problem.'' If there was any outstanding balance after five years, he said, the borrower could repay the remaining principal, reapply for a new five-year loan at the rate in effect at that time, or repay the principal over 15 years, again at the prevailing rate.
Bank of New York isn't the first to put a cap on these loans, he acknowledged. Banks in Philadelphia, Chicago, Boston, and other cities are starting to put limits on how high home equity loans can climb.
When borrowing against equity, homeowners should make sure their payments will cover both interest and principal. ``If they're not careful, people can wind up refinancing their whole house to buy a car,'' says Ralph Presutti, a financial planner with Advest Inc., a Hartford, Conn., brokerage. If this happens, the home equity loan is ``front loaded'' with interest, like a normal first mortgage. By the time you're ready to sell the car, you'll find that all those monthly payments did nothing but cover the interest; the debt for principal is still there.
To avoid this problem, Mr. Presutti suggests using a home equity line of credit where you just borrow the money you need and interest charges are levied only on the unpaid balance.
Some banks have made tapping home equity even easier by letting people use a credit card. So far, only about 100 commercial banks and a few savings-and-loans are offering this option, but the pace has picked up this year.
While many consumer groups have expressed great concern about these cards, some banks are trying to make them harder to abuse. One way is a credit limit lower than you could get with a normal home equity line of credit, but higher than an ordinary credit card. Other banks have a higher annual fee, perhaps $50, to help limit them to people who can afford more debt. Still, these cards can be very dangerous and so call for a great deal of discipline. Although banks cannot control exactly how they are used, most recommend they be used only for major purchases that might have required some debt anyway, like a car, home improvements, or equipment needed for a business run out of the home. They should not be used for current consumption, travel, or entertainment.
Because the rates on home equity loans are often lower than loans for cars or boats, many people are using equity loans, figuring that if they get into financial difficulty, they can always sell them.
One problem with this, however, is that tax reform is phasing out the deductibility of most of these loans, as well as ordinary auto and boat loans. By 1991, the deduction for all interest except home mortgages will disappear.
Some banks, however, are finding creative ways to make car loans deductible under tax reform.
Goldome Federal Savings Bank in Buffalo, N.Y., for example, has a ``special-interest loan'' that can be used for a car, boat, recreational vehicle, or mobile home. The term, or number of years of the loan, is the same as on a car or boat loan, but the bank takes the lien against the home.
The rate on these loans is slightly lower than for an ordinary car loan, and, unlike most home equity loans, the rate is fixed for the full term, a bank spokesman said.
Even though loans like this will probably spread, homeowners must still consider carefully whether a shiny new car and ``outsmarting'' the tax code (which Congress may eventually tighten anyway) are worth the risk to their homes.
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