The Dangers of Home Equity Lending

Katy owned a nice house in a Los Angeles neighborhood where prices had been growing at a double-digit clip. But the rising value of her home wasn't making Katy wealthier. Instead, every year or so Katy would drain off her equity to pay credit card bills, replace her late-model car, or take a vacation. She thought she was being smart by taking on tax-deductible debt. Instead, she was blowing her most important asset with pretty frivolous spending.

Her borrowing got to the point where she had very little equity left. When she tried to refinance her home loans, she learned that lenders wanted to charge her much higher interest rates because her existing house debt already totaled nearly 100% of the value of her home. (You get the best rates on home equity lending if your total borrowing equals 70% or less of the value of your home; once you get to 90%, rates really spike.)

What's more, Katy had left herself very little maneuvering room in case of emergency. Many people have to fall back on borrowing their home equity when confronted with a financial disaster like a job loss, catastrophic illness, or divorce. Since Katy had already “consumed” her financial cushion, she would have been in a pickle if she'd needed to get her hands on money fast. (As a rule of thumb, you should try to keep an equity cushion of 20% or more in your home.)

Another risk she faced was losing her home. If money got tight and she missed enough payments, her home equity lender could foreclose on her house. When interest rates were low, that didn't seem like much of a possibility. As rates rose in 2005, though, she found herself having more trouble making her minimum payments.

Using up all your equity in a fast-rising real estate market poses another, more hidden danger. Hot markets can cool suddenly, and prices can drop—as they did in Los Angeles in the early 1990s. Homes on average lost 20% of their value; some plunged 40%. If Katy had to sell into a falling market, she could find herself owing more on the house than she could sell it for.

All the dangers of home equity borrowing haven't dampened homeowners' appetites for these loans, however—far from it.

Home equity lending has soared tremendously in recent years, as shown in Table 5.1. New borrowing grew by nearly four times in five short years, and the amount we owe on home equity loans and lines of credit, $719 billion, now exceeds the balances on our Visas, MasterCards, and other general-purpose credit cards.

These figures reflect only mainstream home equity lending and don't include loans to folks with bad credit. This “subprime” mortgage market has grown even faster and now totals more than half a trillion dollars.

Less than a third of all this borrowing, lenders say, is used for anything that could remotely be considered an investment, such as home improvements or education. The rest goes for debt consolidation, vacations, or purchases of assets that quickly depreciate, such as cars.

Before we get into good and bad uses of home equity, though, let's review some of the basics.