Magazine article Journal of Commercial Lending

The Risks of Home Equity Lending

Magazine article Journal of Commercial Lending

The Risks of Home Equity Lending

Article excerpt

Home equity products came into being after the enactment of the Tax Reform Act of 1986. The act eliminated personal interest as a tax deduction but allowed home owners to deduct the interest paid on a second mortgage or deed of trust if certain Internal Revenue Service (IRS) guidelines were met.

Currently, the law allows home owners to use a principal residence (or second residence, which could include a large boat) to secure up to $100,000 worth of equity loans or lines of credit, with no limitation on the use of the proceeds.

The government's presumption underlying home equity loans was that consumers would use the funds to purchase cars, pay college tuitions, take vacations, or make home improvements, thereby stimulating the economy. However, many consumers have also found that home equity loans can be a source of working capital for small businesses and farms, a vehicle to consolidate consumer debt, and a means to supplement family income. Some lenders give little attention to the possibility that customers using home equity loans can become "upsidedown," that is, borrow long for short-term purposes.

Marketing Strategies

Banks promote home equity loans by attracting potential borrowers to their institutions through advertising campaigns and by stressing the product's tax advantages. Customers are sometimes bombarded with inserts in their account statements, direct mail correspondence, and media blitzes. The advertising message is simple: Home equity loans are fast, easy, and "smart," in that the home owner can enjoy a tax deduction on the interest paid.

This advertising rhetoric, however, often fails to stress the terms and conditions of these loans. Collateral, fees, interest rates, interest rate adjustments, and loan terms are never the main theme of an advertising campaign. What seems like a quick fix for the home owner's cash deficiencies can have a long-term negative effect on his or her financial future. Thus, with one swift motion, the banking industry has delivered a consumer product that has penetrated the last bastion of American savings--the home. Perhaps, then, home equity loans should carry a caveat akin to the Surgeon General's old warning on cigarette packs: Home equity loans may be hazardous to customers' financial health.

Why are home equity loans so appealing to banks? Current low interest rates coupled with an excessive amount of funds available for lending create smaller net interest margins and declining income for banks. With lower yields and strong competition on the commercial side of banking, consumer lending can pick up the slack and help maintain earnings.

In addition, home equity loans further tie a customer base to the bank, are easily marketed, and command fees or interest rates commensurate with other consumer loan transactions. Because every home owner is a possible candidate for this type of loan, an institution can quickly build a portfolio and generate income. However, the banking industry has the responsibility of serving both the customer and the community properly.

Credit Standards

The competitive nature of the U.S. banking system propels home equity lending. A customer who does not like the terms and conditions of one financial institution may find another lender that offers a better deal. In addition, the banking industry is under constant competitive pressure from nonregulated institutions that now offer traditional banking services. Such competition further pushes the banking industry to be market driven rather than credit driven.

Nevertheless, financial institutions must set reasonable underwriting standards. The following areas deserve consideration when developing bank policy or strategy for home equity lending:

* Loan maturities and dollar limitations.

* Interest rates and fees.

* Principal reductions and loan-to-value (LTV) ratios.

* Appraisals. …

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