Many homeowners who were once underwater now find that not only are they high and dry, but that their home sits above a well of cash.
Home equity — defined as the difference between a home’s current value and the amount of principal owed on any mortgage — took a big, $2.2 trillion leap from 2012 to 2013, according to U.S. Federal Reserve statistics.
The recovery in housing prices means that many owners’ mortgage balances no longer loom above their home’s value, a situation known as being “underwater.” Many homeowners might be able to do the unthinkable a few, economically distressed years ago: Take a second mortgage.
Indeed, Moody’s Analytics predicts the dollar volume of equity credit will rise about seven to eight percent in 2014.
Right and wrong
But just because you can doesn’t mean you should take on added mortgage debt, warns Ellen Schloemer of the Center for Responsible Lending, a nonprofit consumer protection group.
“Some reasons for borrowing from home equity are better than others,” adds Cleveland financial planner Kenneth Robinson. Spending on a home improvement that will provide a lasting boost to a home’s value could be a “better” use, he says.
On the other hand, says Dublin, Ohiobased financial planner Carol Friedhoff, if the borrowed funds are spent on something that’s quickly consumed — like a vacation — and doesn’t provide a lasting value, “then it’s ‘bad debt.’”
Truth be told
Consumers are somewhat protected from “bad” debt, since lenders have a stake in ensuring the equity won’t sink their finances, says Keith Gumbinger of mortgage data firm HSH.com.
Expect questions on what the equity funds will be used for, says Dan Gjeldum, senior vice president of mortgage firm Guaranteed Rate.
Then, lenders will try to ensure that funds are used for their stated purpose and don’t enable a borrower to fall into deeper debt. For example, Gjeldum says, “If someone is consolidating credit card debt, they may be told to bring in their statements and the credit card accounts will be paid at the closing.”
During the boom preceding the housing crisis, lenders didn’t worry much about what borrowers did with their funds. “One of the biggest reasons these loans went bad was because people said they were going to pay off a credit card but didn’t,” Gjeldum explains.
Now, lenders try to ensure borrowers aren’t able to get into more debt because of the equity credit. All debt shouldn’t exceed about 40 to 43 percent of a borrower’s income, Gjeldum says.
Still, lenders can’t know if borrowers might open new credit accounts later. Robinson advises using equity to consolidate credit cards only if people “have demonstrated — not resolved, but demonstrated — that they no longer use the credit cards for over-spending.”
Hold it there
Here’s another housing crisis lesson: If home values drop, so does the amount of equity an owner has, and a second mortgage could be the added debt that pushes an owner underwater.
Owners now need a relatively large amount of equity in a property to borrow against it, Gjeldum says. At least 10 percent — usually 20 percent — of the value of a home should still be mortgage-free after the equity loan.
Most equity lending is in the form of a “line,” Gumbinger says. “Equity loans are harder to find.”
In the case of a home equity line, the borrower pays a variable interest rate on the money he or she has drawn. In contrast, an equity loan is one lump sum usually with a fixed interest rate charge.
In some cases, the lines require interest only payments for an initial period, like five years, and then the balance is due, says Charles Chedester, past president of the Mortgage Professionals of Iowa.
Yes, lending rules are more restrictive, but consumers should still be careful. “Anyone who doesn’t read the documentation could get a surprise,” Gumbinger says.
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