More debt, less equity leaves more homeowners on shaky ground
By Michael D. Larson • Bankrate.com

Home buyers have been purchasing more expensive houses with less money down while homeowners have been tapping into larger amounts of equity by refinancing, according to recent studies and mortgage industry data. Now, some worry the bill for this excess will soon come due.

The ongoing U.S. economic expansion -- which has given people both the confidence and the means to spend freely -- shows signs of winding down. At the same time, higher interest rates, increasing gasoline prices and other forces are taking their toll on people's wallets. Mortgage consumers who've borrowed extensively or are thinking about doing so could be in for some problems if they don't start cutting back.

"Consumer confidence is very high and any time you have high consumer confidence and a low history of defaults, what you tend to see is people borrowing more," says Anthony B. Sanders, a professor of finance and real estate at Ohio State University in Columbus. "A lot of the borrowers in the market today have very little history to look at, and we've seen basically over the last eight years or so housing prices doing very well with steady upward growth.

"But there are a lot of families in the United States who are financially getting in way over their heads," he adds. "With a number of economists calling for a slowdown in the economy, whether it's a soft landing or a hard one, I think a lot of families are going to be in for a massive wake-up call."

The Gay '90s
It's easy to see why borrowers have collectively said "Laissez le bon temps roulez!" when taking out mortgages. Since the beginning of the 1990s, home prices have increased 45.6 percent, according to Freddie Mac figures. Average 30-year mortgage rates have dropped as low as 6.5 percent from just shy of 10 percent during that time, Bankrate.com archives show. Meanwhile, unemployment has steadily fallen to around 4 percent while stock prices have risen to the point where "Dow 10,000" seems like an anachronism.

The good times have encouraged some people to borrow more while allowing others who would never have qualified for loans before to do so. Some put less money down because they think they'll profit more off cash invested in stocks than cash plowed into real estate. Others simply have no choice. They haven't saved because the economy's strength has encouraged them to spend most of what they earn. Yet they aren't being told by eager lenders, "Come back in a year when you can put a few thousand dollars more down and have more emergency cash saved up."

As a result, an increasing number of homeowners don't have much of an equity cushion built up in their properties.

In 1991, for example, only about one in five home purchase mortgages backed by private mortgage insurer Mortgage Guaranty Insurance Corp. were for 95 percent or more of the value of the properties securing them. Today, more than half fall into that category, according to Geoffrey Cooper, director of public policy for the Milwaukee, Wis.-based company.

"You've had an infusion of first-time home buyers," Cooper says. "The first-time home buyers of today are people who need lower down-payment mortgages and perhaps expanded debt ratios and credit leniency to some degree."

Gettin' while the gettin's good
But the equity problem extends beyond new home buyers. Current owners are mortgaging their equity away, too. In the second quarter of 2000, more than four out of five borrowers increased their mortgage debt load by 5 percent or more when they refinanced, according to numbers complied by Freddie Mac. On an annual basis, the percentage of people increasing their balances by that much hasn't been this high since 1990.

A separate Federal Reserve Board study of the 1998 and 1999 refinance boom showed that more than one-third of borrowers took cash out of their homes when they got new loans. That compares to the 25 percent found in a Fed survey conducted after the last refinance surge in the ear1y '90s. People tapped substantial amounts of equity too, according to this July's study. The average amount consumers cashed out was just over $18,000, while about one in four borrowers took out $25,000 or more.

"Mortgages remain tax advantaged relative to other types of borrowing. That is, you can deduct the interest on your mortgage from your tax returns. You can't do that with your auto loans or things like that. Families have probably over time shifted more toward using mortgages on a home as a vehicle to finance some other acquisitions," says Frank Nothaft, deputy chief economist at Freddie Mac. "A second reason is that borrowing with a home mortgage is less expensive than borrowing with an auto loan or credit card loan or something else that isn't secured.

"Another contributing factor is we've had some very good, solid appreciation in homes in recent years," he adds. "That's provided kind of the additional equity cushion that a family now has that they could borrow a little further against."

Economic storm warning
Yet all of this mortgaging could cause problems over the next several months, especially if the tentative economic slowdown that seems to be in the works gets worse. It doesn't take many layoffs before people who are on tight budgets start missing payments.

"Right now, we have an economy where literally firms cannot employ enough people. We are effectively the full employment economy right at the moment," Sanders says. "But a lot of people really don't know what it's like to be out of work and suddenly have to pay for a Ford Explorer or Lexus SUV, put the kids through college and make a huge mortgage payment when they're unemployed."

More homeowners could run into trouble too because a broad economic slowdown would cool the real estate market as well.

Home sales are already falling and that could make it harder for people who think that even if they get in trouble, they'll still be able to sell their homes to get out of it. If homes stop appreciating at their recent rapid clip, people who bought with high-LTV loans could be in especially bad shape. Some will find that after deducting real estate agent fees, they actually owe money at closing.

Consumers who want to avoid problems might want to consider holding off before buying homes at super-high LTVs until the economic picture becomes clearer. Experts say those who already have loans for as much as or more than their home values should work hard at paying down that debt. Before refinancing away their hard-earned equity, homeowners should also stop to think about whether it's really worth it. After all, there's still something to be said for owning a home free and clear and that's a luxury people postpone every time they boost their mortgage debt.

"Consumers are leveraging their future on the expectation that the economy will stay good and that they'll be able to repay these loans without a lot of difficulty," says Jean Ann Fox, director of consumer protection with the Consumer Federation of America in Washington. "In a perfect world, that would be OK, but we know the economy has cycles and eventually it may not be so easy to carry this debt."