Real Estate: Equity Comes Home
Rising home prices may be bad news for prospective homebuyers, but it’s good news for homeowners scrambling to cash in on their newly valuable homes.
Remember mortgage burning parties? Decades ago, homeowners gathered around mini-bonfires to celebrate the end of the bank’s lien and the beginning of “true” homeownership. Not anymore. Paying off a mortgage seems quaint at a time when people celebrate the chance to refinance their homes at lower interest rates—even if it means starting the clock on their mortgage over again—or borrow against their equity to make life easier.
Higher home prices means more access to home equity financing, giving existing homeowners a new reason to party. Gayle Ishima, president of the Hawaii Mortgage Bankers Association, says this reflects a generational shift in attitudes toward debt: “The older generation wouldn’t touch the equity in their homes unless it was a matter of life or death, because they were geared toward paying off their mortgage. Now it’s more about cash flow.”
Why is home equity financing popular now? The simple answer—because the equity is there. A decade ago, negative equity was the norm as home prices nosedived, leaving some homeowners with mortgage balances larger than what their homes were worth. According to Ishima, “The ’90s were really tough. We saw foreclosures where people with two good jobs were laid off through no fault of their own, and they couldn’t sell their home to pay off their mortgage because they were underwater. It’s better now because over the last four years, almost everyone has built up equity.”
Generally, equity is the value of a home deducted from the outstanding balance owed by the homeowner. The bigger the difference between the homeowner’s balance and the tax-assessed value of the home, the bigger the equity, and the more credit a homeowner can access, says Jim Patterson, vice president of residential mortgage at American Savings Bank. Typically, home equity loans are given up to 85 percent of a home’s appraised value.
Nationwide, homeowners are borrowing against their equity more than ever, with the average equity line of credit increasing from $69,513 in 2003 to $77,526 in 2004, according to the Consumer Bankers Association. That’s double the national average in 2000: $31,000. Hawaii homeowners borrow even more. The current average home equity line in the Islands is $100,000, according to Bank of Hawaii, the largest home equity lender in the state.
Traditionally, homeowners use equity financing to remodel or expand their existing home, or to pick up an investment property. Whatever the money is for, borrowing against a home’s equity can take two different forms. In one, the home equity loan—also known as closed-ended second mortgages—lenders provide borrowers with a lump sum up front, with standard monthly payments. These loans are most useful when the homeowner needs a large, one-time infusion of cash, say to put a significant down payment on a new home, either as an investment, or to help out children buying their first homes.
The other form of borrowing against your equity is to establish home-equity lines of credit for a fixed period, typically 10 years. This option is best for those who need a standby source for emergencies, or those who need to borrow relatively smaller amounts over a period of time, say for college tuition expenses or to renovate one section of their home at a time. Most lenders provide access to lines of credit either with a checkbook or a credit card, so that borrowers can access the amount they need. As with traditional credit cards, borrowers only pay on the amount that they use. Interest rates typically vary on a monthly basis. However, First Hawaiian Bank and Bank of Hawaii have equity lines that allow borrowers to lock in rates for fixed amounts for a year or more.
Because home equity lines of credit are so easy to use, with familiar instruments like checkbooks and credit cards, homeowners these days use them to fund everything from weddings to debt consolidation to vacations. The most obvious benefit: low interest rates compared to other types of consumer debt. Most lenders base their interest rates on the prime rate, as published in the Wall Street Journal. In late February, that rate was 5.5 percent. By comparison, the average fixed rate for a standard credit card was 12.93 percent, and 13.38 percent for those with a variable rate, according to Bankrate.com.
Another benefit: the interest paid on debt secured by a mortgage or lien on your personal residence is tax deductible, in most cases. According to IRS Publication 936, limits on home mortgage interest deduction depend on several factors, such as dollar amount, income bracket, primary and secondary home value. Generally, the amount of interest deduction you qualify for is limited if: your adjusted gross income is more than $137,300, and your mortgages on primary and secondary homes exceed $1.1 million ($1 million for the combined mortgages and $100,000 on a home equity loan).
But homeowners shouldn’t let the benefits of home equity financing lead them into trouble. As with any tool, there is a right way and a wrong way to use it. Home equity financing is long-term, so people should think carefully about using it for short-term debt. Conventional wisdom says that borrowing is best used on a purchased item that has a similar expected life as the loan. By that measure, John Gray, Bank of Hawaii executive vice president for mortgage lending, says paying off credit cards with a home equity loan doesn’t always make sense: “Credit cards are designed to be short term [loans, so] it doesn’t make sense to turn it into a 15- to 30-year obligation.”
Patterson from American Savings Bank says that can apply to car purchases as well: “Generally, if you think about taking out a 15-year loan, it may not be best to use it for a car loan if you’re going to sell the car in five years.” Similarly, it doesn’t make sense to make only the minimum payments on a 15-year loan. “You don’t want to still be making payments on the old car even after you’ve bought a new one,” says Patterson.
However, using a long-term financing instrument could work on short-term loans, with the right strategy. Gray says the key to that is discipline: “I would say, take advantage of the low interest rates [for home equity loans or lines of credit] but treat it as a short-term debt and pay it down in three to four years.” Still, Gray acknowledges having that much wiggle room can be tempting: “It’s like the low-carb diet–it’s easier said than done.”
Besides loans and lines of credit, senior citizens 62 years and older who have built up significant equity in their primary residence can take out a reverse mortgage, which converts part of the equity in the home into tax-free income. While upfront costs may be high, borrowers never owe more than the value of the home after the mortgage is taken out. Cash can be taken out as a lump sum, a line of credit or a monthly distribution. The term “reverse mortgage” implies that homeowners will be selling their home slowly to their bank. On the contrary, homeowners continue to own the home but will need to repay the entire amount, including interest, if they sell the home or move away. Whatever the homeowner draws down reduces the equity that would have otherwise passed to heirs after death, but heirs will retain title to the property for whatever equity remains after the loan is repaid. Says Gray of Bank of Hawaii: “It’s a good way to keep an individual in their home if they don’t have the income.”
The bottom line: home equity financing, in any form, is essentially a lien on your home, so it’s best to have a plan to pay off the loan. It’s an attractive option from a borrower’s perspective, but it comes with a significant tradeoff, says Ishima: “If you don’t make a payment on your credit card, you won’t lose your house … If you want to use your home equity to go on vacation to Las Vegas and gamble, that may be an OK use, but know that you may end up paying for it with your house.”
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