Richard F. DeMong is a longtime follower of mortgage market trends. A professor for 20 years, his research on home equity lending is widely quoted and he has taught seminars on equity analysis. His current research focuses on mortgage and home equity lending to prime and subprime borrowers. Here, Bankrate talks to professor DeMong about how home equity fits into the complete financial picture, how best to leverage it and how to get out and stay out of repayment trouble.
Hometown: Charlottesville, Va.
- Virginia Bankers professor of Bank Management, McIntire School of Commerce
- Director of Center for Financial Research at University of Virginia
- Recipient: Chartered Financial Analyst Award (CFA)
- Research director, financial analyst Research Foundation (1982-1985)
- Retired Air Force colonel from the Air Force Reserves
- Written extensively for professional journals, including the Consumer Bankers Association and Journal of Retail Banking, on home equity lending and subprime lending, as well as bank investments
What is the role of home equity in a person’s overall financial success?
I always look at the home as an excellent investment in most situations; it gives you a place to live as you pay it off and build an asset. You may want to move to a smaller home or condo in retirement and then it’s an excellent source of retirement funds. Reverse mortgages are becoming more popular. If the loan doesn’t have a lot of fees, this is a good source of money for people who don’t want to move.
How are homeowners doing when it comes to creating equity in their homes?
Creation of equity is a function of paying down a mortgage as well as the price appreciation in a home over time. So equity is created by the market as well as the person paying money into their home. I’ve argued for years that borrowing to improve your home is one of the best uses of home equity lending in that it improves the value of the home if the improvement is well done. And it is less risky for the lender, because when you improve your home, you improve the value of the loan collateral.
Why should a homeowner borrow?
Home equities today are used for far more than home improvement. People use them for buying a car instead of taking out auto loans; sending the kids to school and paying for room and board; for taking vacations and additional luxury items, or anything the heart desires.
I think it’s a very good thing. If you’ve got the equity available and you want to borrow some of it, I say go for it. It’s tax deductible. And, you’re taking cash out of a nonliquid asset. However, home equity borrowing is a good thing depending on the person.
What about home equity borrowing to consolidate debt?
It’s a great idea to use home equity to consolidate debt, but with the caution that the borrowers don’t run their cards up again. Otherwise, they’ve used up the value in the home and they’re still in debt.
Yes, you’re putting your house on the line, but if you didn’t pay your credit card, you could be thrown into involuntary bankruptcy, so there’s still risk there.
What trends have you observed?
Home equity lending took off dramatically in 1986 with changes in tax codes and has continued to increase since then. One thing that has changed over the last two decades is that people are able to borrow 100 percent and at one time lenders were going up to 110 percent – borrowing on future equity. Many lenders have gone back on that. We have seen a huge increase in the percentage of equity people are borrowing and lenders are willing to lend. The cutbacks are due to foreclosures first, bankruptcies second. Lenders have become more cautious over the last year.
Is this increase in lending percentages new or is it cyclical?
It’s been going on for the last decade, at least. Success requires a very strong economy and a belief that home prices will continue to increase dramatically. I don’t see that happening anytime soon.
Is high-percentage borrowing dangerous?
I have argued that it’s dangerous for many borrowers because, in effect, you’re borrowing against your home. That has two dramatic disadvantages for the typical borrower. One is if you default on your mortgage loan or home equity line or loan, you may lose your home. The second concern I have is that for U.S. investors, the home is typically the biggest investment that they have. And if they borrow against it, what are they going to retire on? It could potentially cut into their retirement sources of finance.
The other thing I have observed, watching home equity since 1986, is that the margin and fees that lenders charge has decreased. The margins have become much more competitive. Consumers are borrowing, trying to live to their heart’s extent. So, we have both a willing supplier and willing borrower/demander.
Which fees in particular should borrowers look out for?
Watch out for all fees. The Federal Reserve and the Federal Trade Commission have excellent guides for potential home equity borrowers.
Which are the most egregious?
Arrangement and application fees are often resented by the borrower. I urge borrowers to carefully check and understand all fees as they apply for a home equity loan and at closing. Don’t sign the application or the closing documents if you are uncomfortable with the fees. Borrowers should understand they are in the driver’s seat when applying for a loan at a particular lender. They can always try to get a better deal at another lender.
Which get people into the most trouble?
Prepayment fees, which are often a tradeoff for lower interest rates, are a problem for borrowers if they are able to pay off the second mortgage early because of a good fortune or because they sell the house. Transaction fees can also be a problem for borrowers that make frequent draws on their home equity lines of credit.
Are any negotiable?
All fees are negotiable. Stamp or recording fees have to be paid by someone (borrower or lender), but the others can often be negotiated away.
Despite admonitions about the importance of reading and understanding all contracts before signing, it seems that many Americans know very little about the terms of their home equity borrowing. What tips would you give for reading contracts?
The major caution for individuals is make sure you understand the loan, that you understand what the interest percentage is and what it might be a year to three years from now. A lot of borrowers are saying they didn’t realize the interest rate was a teaser rate and would go up later, even though it was clearly stated in the contract. Make sure you know what the interest is today and might be a year or two from now. Many people don’t.
Read the contract. As your mother said, ‘Don’t believe everything you hear,’ and that really is true with a loan transaction. She also probably told you not to believe everything you read, but at least if it’s written, you have some legal standing to say ‘but that’s not what they told me.’ I guess the first caution is to read it, but if you’re saying you really don’t want to read it, then read the interest rate today and the maximum interest rate of that loan and if you don’t understand it, ask to have it explained. Then read through all fees. Understand what the fees are and what you’re really borrowing. Crunch the numbers with the Bankrate amortization calculator.
What would you suggest to homeowners who find themselves in trouble with their equity loans?
Be honest with the lender; call the lender right away. Ask to work out a delay. I think it always pays to be straightforward with the lender because the lender is going to want to work with you to make sure the loan is paid at some point. Nobody wants to get stuck with a house, especially in today’s market. Housing prices are stagnant.
What are the danger signals of a bad loan?
I don’t think we’ve seen many dishonest lenders. What we have is some dishonest mortgage brokers – folks who help you with the paperwork and send it off to the lenders. The danger that people talk about is if the mortgage broker is calling you to refinance a loan that you just took out six months ago or so. This is called flipping. Often the mortgage lender has a conflict of interest because the mortgage broker gets commission and fees for every time you refinance a loan. So flipping is a major issue.
Where can borrowers turn if they feel their mortgage broker has misrepresented the loan or if they don’t receive the good faith estimate?
Most states have consumer protection offices. The federal regulators: Federal Reserve, U.S. Department of Housing and Urban Development, Office of Thrift Supervision, Federal Trade Commission, Federal Deposit Insurance Corp., National Credit Union Administration and Office of the Comptroller of the Currency are helpful. For a complete listing of federal regulatory addresses, visit federalreserve.gov.
What other things do you see coming down the pike?
Subprime lending and foreclosures are big issues. I can’t imagine much more than that.
Is subprime borrowing ever a good idea?
Subprime borrowing is borrowing when you don’t have a perfect credit record. The term generally refers to mortgage debt. It’s often referred to in its FICO score, which was published by Fair Isaac. The old rule of thumb was that a FICO of less than 620 or 630 was considered subprime, but now that’s tightened up to 670 because lenders have gotten more careful in their lending standards.
Subprime borrowing can be a dramatically bad idea if the borrower can’t pay the loan back. But, for folks who have a blemished record, it gives them a chance to re-establish themselves and buy a home. Again, if you borrow more than you can pay back, you’re going to be in a worse position than you were to begin with. But, I think it plays a very useful role in society.
Subprime also includes no-doc loans. We’re finding out a lot of people fudged their income. But it made a lot of sense for folks with erratic income, such as actors and startup entrepreneurs. They may not be taking a salary because they’re putting all their income into the business. Those are the people I’d want to lend to.
Will consumers with good credit be affected?
Yes, in that the lenders are going to take a second look before they agree to take the loan. There will be more scrutiny. The rates are going to go up, but not just because of this.