|125% mortgages risky
for borrowers, lenders
If Dan Marino backs something, it's got to be
good, right? After all, the long time Miami Dolphins quarterback
has been a National Football League star since the early Reagan
But among all his endorsements, one product
pitched in recent months -- so-called 125 percent "high-LTV" home
equity loans -- rubs some experts the wrong way. The 125s are usually
second mortgages that, together with first liens, leave homeowners
with debt that exceeds the value of their homes.
Playing with fire
Lenders promote them as a tax-deductible tool to consolidate debt
or make home improvements, and say they stick to high credit and
income standards when underwriting them. But consumer advocates
and regulators warn the loans pose a serious financial risk to lenders
and borrowers alike. And, in times of economic uncertainty, that
makes getting one akin to playing with fire.
"I don't like them at all," says Marilyn Steinmetz,
a certified financial planner with Money Matters in West Hartford,
Conn. "I don't like putting people in the position of debt, or heavy
debt, that often they can't get out of, and then they lose their
Home equity products have long been a staple of the lending industry.
Traditionally, companies would be willing to extend both first mortgages
and home equity loans, but didn't like to see a person's total debt
load rise to unmanageable levels. One guideline is the loan-to-value
ratio, which measures the value of the loans against the assessed
value of the collateral, in this case, the home. Loans of $80,000
on a $100,000 house, for example, result in an 80 percent LTV --
the traditional level beyond which old-line lenders didn't want
to extend credit.
But just as the amount people need to put down
to get into a house has shrunk, the amount of total debt they can
assume has risen. In the last few years, certain lenders have been
pushing the envelope further and further, with some advertisements
and published reports indicating 150 percent, or even 165 percent,
LTVs are available. The 125 percent loan, however, is much more
popular and widely promoted.
The product works like this: Say the borrower
still owes $80,000 on the first mortgage on a $100,000 home, but
nevertheless qualifies for a home equity loan. The homeowner borrows
an additional $45,000 from a second lender, making the combined
mortgage debt $125,000, or 125 percent of the value of the home.
all goes well
If all goes well, the lender makes a substantial profit from payments
because the loans typically carry interest rates of 13 percent or
14 percent, says Jeffrey Zeltzer, executive director of the National
Home Equity Mortgage Association. The borrower, in turn, gets
to retire higher-rate credit card or other debt by converting several
balances that don't feature tax-deductible interest into one home
equity balance that may.
"Ideally, and in the vast majority of cases,
it is an A-plus borrower, with a long time on the job and high income,
who has purchased the home, has gone through the growth spurt --
the furniture, the swimming pool and all that -- and who says, 'Hey,
I think I want to consolidate my debt,' " Zeltzer says. "These are
borrowers who have a strong likelihood of remaining on the job."
But that is by no means the whole story when it comes to 125 percent
home equity loans. Consider the details of the tax-deductibility
Ron Kotick of H&R
Block Premium in West Palm Beach, Fla., explains that interest
is generally tax deductible on loans that do not exceed the value
of the home. However, if the loans are big the tax benefit disappears
at a certain point. Only the interest on the first $1 million of
a first mortgage loan can be deducted.
In the case of home equity loans, the tax benefit
applies to only the first $100,000 of loan principal. Furthermore,
tax deductibility doesn't apply to any portion of the loan that
exceeds the value of the home. So, our sample homeowner would be
able to deduct the interest on the $80,000 first mortgage and the
first $20,000 of the home equity loan -- but not the interest on
the last $25,000 balance of the home equity loan.
"What they have is personal interest for the
remaining 25 percent," Kotick says.
To make matters worse, the "alternative minimum
tax" may kick in if the homeowner uses the home equity loan for
anything other than home improvements. Because it's so difficult
to judge whether the AMT will apply, Kotick says people should check
with a tax adviser if they plan on using the loan proceeds for something
other than a new deck or pool. Typically, however, the tax would
hit couples who make between $70,000 and $100,000 a year.
When it comes to 125s, Zeltzer says lenders are picky. They want
to see a steady paycheck and high-quality credit in the form of
a superior credit score. For instance, a score of 660 typically
guarantees a borrower will be able to obtain a first mortgage. However,
in a recent group of high-LTV loans originated by FirstPlus Financial
Group Inc., the average credit score was 689.
While such a score may ensure a history of good
credit habits, experts note that it can't predict a lost job, divorce
or other financial crisis. That's not a problem for most homeowners,
because they can always move to a smaller house or sell their property
entirely to raise money. People with loans in excess of the value
of the homes, however, need to settle the second lien holder's debt
in order to sell their property. Or, in simple terms, they will
pay money at closing rather than receive it.
"The issue becomes, how do you clear the title
of record because you now have two liens," says Laura Borrelli,
president of the National Home Equity Mortgage Association. "From
a pure technical standpoint, the borrower would be required to come
up with all the cash to pay the lien off."
Some lenders may make the second loan "portable" by allowing borrowers
to apply it to whatever new property they inhabit, she adds. That
would keep customers from defaulting and lenders from losing their
source of income. But borrowers would have to be current on payments
in order to qualify, and the lender doesn't have any contractual
obligation to allow the transfer.
If borrowers can't take the loans with them,
defaulting on the debt and going through foreclosure, or even bankruptcy,
may be next. But customers with 125s can take heart in one thing:
Experts say the amount of the loan above and beyond the home's value
is considered unsecured, just like a credit card balance. That means
the lender doesn't have a right to snatch assets to recoup whatever
loan balance wasn't secured by the home.
"When the loan is high in relation to the value
of the collateral, you've really got to do more work on the borrower's
repayment capacity. High-LTV implies you don't have much protection
in the case the borrower can't repay," says Dave Gibbons, deputy
comptroller for credit risk at the U.S. Treasury's Office
of the Comptroller of the Currency. "You don't have as much
to fall back on."
That extra risk has caused investors to shy away from putting their
money in securities backed by these loans in the past couple of
months. As a result, several lenders who specialize in high-LTV
loans have scaled back their operations or filed for bankruptcy
Such moves, however, should not affect the terms
of a borrower's loan. Typically, groups of loans held by defunct
companies are sold to others in the industry and borrowers would
experience nothing more than a change in where their payments go
-- much like the standard "servicing transfers" done with traditional
"The (lender's) creditor is going to get ahold
of those assets and determine who to sell them to, but the terms
of those contracts ... are not going to change," says Mark Hikel,
former president of a subsidiary of Southern
Pacific Funding Corp., a high-LTV firm which recently filed
"The borrower's ability or responsibility to
pay back the loan is not affected by the (company's) bankruptcy."
-- Posted: Oct. 28, 1998