NEW YORK (MainStreet) — Millions of homeowners owe lenders more than their homes are worth, but it turns out that in addition to toxic mortgages and falling home prices, one of the chief culprits of the fallout was the seemingly harmless home equity loan.
New data from CoreLogic, the mortgage data firm, shows the importance of weighing the benefits of home equity loans against their serious risks. Like a sharp knife, a home equity loan can perform well in the hands of a skilled user, but can likewise inflict a mortal wound on the careless.
“Not only was the decline in [home] prices a clear force driving negative equity, but borrower equity extraction also significantly increased the risk of a negative equity position,” CoreLogic says in a report on its findings. “While only 18% of borrowers with no home equity loans were underwater at the end of the first quarter, 38% of borrowers with home equity loans were in a negative equity position. Over 40% (4.5 million) of all negative equity borrowers have home equity loans.”
Without a doubt, falling home prices put many homeowners “underwater”, making them owe more on their mortgages than their homes are worth. But CoreLogic’s findings show that millions of homeowners put themselves in harm’s way by increasing their debt loads with home equity loans.
Once underwater, it can be impossible to sell a home for enough to cover the debt, trapping many people who would like to move for a new job, better schools or a nicer, more affordable neighborhood. Even worse, many underwater homeowners lose their homes in foreclosure.
“Not only does the incidence of home equity loans raise the probability of a negative equity position, but it also raises the severity of that position,” CoreLogic says. “A negative equity borrower without home equity loans is upside down by an average of $52,000, versus an upside-down average of $83,000 for a negative equity borrower with home equity.”
This doesn’t mean home equity loans are to be avoided at all costs, but that they need to be used judiciously.
The chief benefit of home equity loans is low interest rates. A 15-year installment loan, which carries a rate fixed for the loan’s life, would currently charge about 8%, while a credit card might cost twice as much. A home equity line of credit, or HELOC, might start as low as 3%, though it would likely charge more after the monthly rate resets kick in.
Despite the higher starting rate, the fixed, predictable payment makes the installment loan a better choice for a large expense like a major home improvement or college tuition, or any that would be paid off over a long period.