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125% mortgages risky
for borrowers, lenders

Good or bad? 125% LTV loans 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 years.

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."

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The LTV ratio
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.

When 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."

Limited tax benefit
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 claim.

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.

High standards
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."

The risks
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."

Lender troubles
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 protection.

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 first mortgages.

"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 for bankruptcy.

"The borrower's ability or responsibility to pay back the loan is not affected by the (company's) bankruptcy."

 

-- Posted: Oct. 28, 1998

See Also
Related story: High-risk lenders battered by market turmoil
Time to tap your home's equity?
How to deduct home equity interest on your taxes
Home equity loans vs. lines of credit
Home equity glossary
Track prime rate/other leading rate indexes
More home equity stories

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