The Home Equity Loan Zone

It’s time for Home Equity 101. But, don’t worry, it’s not a difficult subject, so you should be able to ace the course. However, what you do with what you learn can, in the long run, effect your life more than your entire grade point average.

Let’s begin with the basics. Your home is worth a certain amount and you probably have a mortgage for part of that. For example, let’s say your house appraises for $250,000 and your mortgage is currently for $200,000. The amount you owe on the loan ($200,000) subtracted from what it’s worth on the open market ($250,000) adds up to the equity you have in your home. In this case your home equity would be $50,000.

See how easy it is? But here comes the tough part. What are you going to do with that $50,000 equity you have in your home? Are you going to keep it there in case you ever have some kind of emergency or want to sell your home and have something left over? Or maybe you even like the idea of paying off your mortgage entirely so you own your home free and clear and no longer have the monthly overhead.

But, then again, maybe you want to take out a home equity second mortgage or a home equity line of credit to be able to access that $50,000. There are lots of reasons you might want to have your hands on that money. Possibly for something like credit card debt consolidation, medical expenses, a college education for your children, taking a vacation to somewhere you’ve always wanted to go or just to have more cash on hand to spend when you feel like it.

However, and here’s the tough part to consider, if you do that, you’ll use up all the equity in your home. And that puts the roof over your head in a shaky position. If anything should happen and you couldn’t cover the extra mortgage payments, the top would blow off of your home investment and you’d no longer have the security of a roof over your head.

So, now that you know the basics, it’s time to see if you have the common sense to make a good, sound, grown-up decision about your home equity.

125% LTV (Loan to Value) loans were always pretty risky, but they’re even more so today.

Today’s home mortgage market is not what it used to be just a couple of years ago. After a decade of record low interest rates and skyrocketing home prices, the “times they are a changing.” Now interest rates are slowly climbing and home values are depreciating fast. So think twice before getting involved with a 125% loan.

An LTV 125% loan is a type of second mortgage. It allows you to borrow more money than you home is worth. For example, let’s say your home is worth $100,000 and you owe $95,000 on your first mortgage. An LTV loan would allow you to borrow $30,000 – the difference between what you owe and 125% of your home’s appraised value.

Sounds too good to be true, right? And that’s exactly why you need to be careful. As the FTC warns, “Borrowers Beware!” You’re not going to get something for nothing. This type of loan, even though it opens up a door for lots of people to borrow, always comes with a high price.

Since this type of loan is also risky for the lender (they can’t get your home in foreclosure), interest rates are much higher and closing costs, etc. often come to more than 10% of the loan balance. There have been stories of interest rates as high as 30% and hidden fees of 20 points or more.

The risk factor also attracts aggressive lenders and mortgage brokers, who work along with high pressure home improvement salespeople, debt consolidation advisors and foreclosure “rescue” companies. Together they persuade the vulnerable, often people on fixed incomes and those with low income and poor credit, into believing that 125% loans are in their best interest.

But, the 125% home equity loan only makes sense if you can get a financially sound deal, which is practically impossible and have more than enough income to cover your higher monthly payments. It’s not for the desperate, no matter how attractive it may sound.

Before making a decision, always do your homework first. Read all the ads. Check out all your possibilities. Work only with reputable lenders. Don’t be sweet talked into something that’s only going to get you deeper into debt. Be safe rather than sorry.

Fed Chairman Ben Bernanke recently warned that too many consumers were jumping into exotic mortgage loans without fully understanding the risks involved. He considered some of these loans to be very risky from a consumer viewpoint.

At a recent speech to the Fed’s Consumer Advisory Council in Washington, Chairman Bernanke said, “Some evidence, including recent Federal Reserve research on consumers holding adjustable-rate mortgages, suggests that awareness could be improved, particularly among borrowers with lower incomes and education levels.”

Many consumer advocates are advising the U.S. Federal Reserve to consider writing regulations to prevent lenders from downplaying the risks involved in new exotic loans. Borrowers must also be better educated about whether sophisticated lending packages such as adjustable rate mortgages, interest only payments and 125% equity loans make sense for them.

One of the major problems raised at the meeting was the rising number of loans being extended to households once considered uncreditworthy. As the mortgage industry became more competitive over the last ten years of rising home prices and record low interest rates, loans made to “subprime” borrowers – people with weaker credit ratings – have greatly increased. In 1994, less than 5% of mortgages were at the subprime level. But by 2005, these loans accounted for over 20% of the market.

But the housing market is cooling off. Interest rates are inching up and home prices are experiencing record breaking depreciation. Regulators are concerned that too many borrowers are at risk for default. And they’ve got good reason. Foreclosures are on the increase all across the country.

What can you do to protect yourself? Well, if you’re already involved in one of these exotic mortgages, you better find out exactly what your terms are, so you can start planning now what your best options are in the future.

If you’re shopping for a new mortgage, do your homework first. Follow the old Boy Scout motto – “Be Prepared.” Learn all you can about the risks of the various loan programs. Know what you’re getting yourself into. Read all the ads. Check out all the possibilities. Participate in mortgage loan chat rooms. Learn from the experience of others. But don’t jump into something without very careful consideration.

And, by all means, do whatever you can to clean up your credit report before applying for a mortgage or any other kind of loan. Just raising your credit score loan by a little bit can probably save you thousands of dollars in interest. So go for it!