Despite drawbacks, high LTV loans return to the home equity game

After an industry shakeout that saw some of the biggest players flee the market or go bankrupt, high loan-to-value home equity loans are returning. These controversial mortgages raise a borrower's debt level above the value of the home -- to as much as 125 percent.

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Lenders tout them as a way to tap home equity, consolidate bills and shrink monthly payments.

The way consumer advocates see it, however, the game remains the same even if the players have changed. Most homeowners still should avoid the loans if they want to keep a bad situation from getting worse.

"I haven't seen a lot of them but I've seen the advertising coming back again," says Jeanne Ciammaichella, housing manager for the Consumer Credit Counseling Service of Northeastern Ohio. "I wouldn't say it's a huge amount, but we weren't seeing anything so I'm kind of worried that it's a trend."

"Every so often, it makes sense to use the equity in your house to pay off debts, but in general we don't even recommend that," she adds. "If you can't make that mortgage payment, you're going to lose your house."

A high-LTV history
High-LTV loans first started appearing on a widespread basis about three or four years ago. Often pitched by sports celebrities, the loans quickly became popular, with their volume shooting up from practically nothing in 1995 to an estimated $8 billion in 1998. During the high-LTV heyday in 1997, a typical loan was for $30,000 and carried an interest rate of 13 to 14 percent, according to a 1998 GAO report on high-LTV loans.

Lenders at the time wanted a new source of profit and a strong economy made the loans look like a safe bet. As time wore on, a secondary market developed, in which many loans ended up bundled together into securities, in the same manner as conventional home loans. The practice ensured both investment banks doing the bundling and lenders doing the lending would make money.

Problems started developing, however, when interest rates declined through mid-1998, souring the profit picture. Lenders had expected rates to remain relatively stable, ensuring them a lengthy stream of relatively high-rate interest payments. When rates fell, people refinanced and closed their equity loans. That eliminated the expected income stream.

"When people were paying off those loans, they weren't making any money," says Dana Barnett, president of Barnett Financial Services Inc. in West Palm Beach, Fla. "You're paying more money out today, but you don't get the money back over the term of the loan."

The industry shakeout
The chain reaction wasn't pretty. Wall Street got leery about the ongoing financing lenders needed to stay in operation and either hiked the cost of their support or cut it off altogether. That prevented some lenders from making new loans and forced others to securitize old ones on unfavorable terms. As a result, many companies shifted to other business, sold themselves to larger competitors or threw in the towel and filed for bankruptcy protection.

Take Costa Mesa, Calif.-based ditech.com, formerly known as DiTech Funding Corp. The company made conventional home loans and high-LTV second mortgages through its retail lending arm and bought equity loans from mortgage brokers on a wholesale basis. After things got hairy last September and October, the company had to take drastic measures. It shut down its wholesale business and yanked information about its high-LTV loans from the ditech.com Web site.

Companies such as FirstPlus Financial Group Inc., which uses Miami Dolphins quarterback Dan Marino as its pitchman, had it even tougher. Its high-LTV subsidiary, which was the biggest in the industry, filed for Chapter 11 bankruptcy protection in March. More recently, the New York Stock Exchange moved to delist the company's shares. The Dallas-based lender did not return several telephone calls and e-mail messages.

Borrowers whose lenders went under had their loans picked up and serviced by other lenders, so they were unaffected.

Companies sell the right to service conventional mortgages all the time, and the process is much the same with lenders who can no longer hold or support their portfolios of high-LTV loans. In such cases, someone else will come along and bid on part or all of a loan portfolio in order to get the right to collect your payments -- and attempt to sell you other products.

For the industry, "The largest problem was the difficulty in obtaining financing, both short-term and long-term, for this product," says Scott Carnahan, president of ditech.com. "Also, I think there has been some statistical evidence from some of the issuers that the product could have some problems. Delinquency and charge-off histories were starting to rise."

The loans rise again
With the shakeout, some predicted high-LTV loans would become a thing of the past. But lenders have proven resilient. Rather than go under, for example, ditech.com agreed to sell itself to GMAC Mortgage Corp. this spring. And with bankers and investors returning to the marketplace, so too have home equity loan pitches.

It's more of a trickle than a flood of new loans, and the few advertisements for them these days are low-key and quarterback-free. To prevent history from repeating itself, the new issuers of high-LTV loans are demanding better credit and higher incomes from borrowers.

Experts also note that lenders are more cautious now than they were before the shakeout, with some limiting the amount available to just barely more than a home's value. That should help keep borrowers with weaker credit or less disposable income from defaulting by preventing them from getting a loan in the first place.

The extra precautions have helped re-create a secondary market for the loans, although many of the investors are just putting a toe in the market.

At the borrower level, people still clamor for high-LTVs. "It's a very easy product to sell to consumers," says Christine Clifford. As a partner with the Columbia, Md.-based research firm Wholesale Access, she studies the residential lending industry.

"These banks, or whoever they may be, mortgage companies, etcetera, don't want consumers to hear that they are doing this product and get swamped with calls because they're not prepared to do huge volume right now."

The lenders who are offering them say life is more convenient for borrowers who consolidate debt with one creditor rather than a half-dozen. They also suggest the single payment will be smaller than the others combined.

They're usually a bad idea
Experts say both claims can be true. But the ultimate cost of a person's debt usually ends up being greater with the high-LTV loan. That's because things like a $10,000, four-year car loan at 8.5 percent end up getting rolled into a $25,000, 25-year second mortgage at 12.5 percent. Including a $10,000, 18 percent credit card balance in the equation makes the move look better. But experts say many borrowers run up their card balance again anyway, leaving them worse off.

Fees that accompany these loans can add to the borrowing price tag as well. Like regular mortgages, high-LTV loans feature closing costs to cover things such as appraisals. These costs -- along with origination fees and other lender charges -- can add a few thousand dollars to the interest-accruing balance right from the start.

Tax deduction limited
While many advertisements suggest that interest will be tax-deductible, the truth is a little more complex. Only the interest on the portion of the home equity loan secured by the house is deductible. For example, a couple that has a home worth $100,000, a first mortgage of $90,000 and a high-LTV loan for $35,000 can't deduct interest on $25,000 of their debt.

Finally, borrowers with high-LTV loans are out of luck when it comes time to relocate for a job or other reason. Because the loans usually have to be paid off, sellers can wind up in the odd position of having to raise cash, rather than receive it, at closing.

Despite its many drawbacks, the product can benefit people who plan to stay in one place for a long time and who have the discipline to keep from adding to their debt load by charging away again.

Nevertheless, finance counselors recommend that people negotiate with their creditors first before turning to an expensive second mortgage. In many cases, they'll find the companies willing to deal rather than lose the chance to get any of their money back.