Negative-Equity Loans Can Be Risky Lifesavers

WASHINGTON — Ballooning credit card debt among American consumers is stoking demand for a new--and potentially risky--home mortgage product: a loan that allows you to borrow not just what your house is worth but up to 125% of what it’s worth.

Lenders across the country are scrambling to offer what some industry analysts believe will be the hottest mortgage concept of 1997. Wall Street mortgage market analyst Jonathan Lieberman, a senior researcher for Moody’s Investor Services, predicts that lenders will make more than $7 billion worth of no-equity and negative-equity home mortgages in 1997, up from $200 million in 1995 and $3 billion in 1996.

No-equity lending appears to turn long-standing rules of real estate mortgage underwriting upside down. Whereas banks historically have insisted on borrowers having some stake in their property--a down payment of 10% to 20% for a new loan, or an equity position of 10% or more for a refinancing--negative-equity lending requires no stake whatsoever.

In fact, according to a new study by Lieberman, most lenders offering negative-equity loans don’t even bother getting a formal appraisal of loan applicants’ homes. They settle instead for what’s known in the trade as a “drive by”--a quick look at the home and the neighborhood--to gauge its rough market value.

The typical no-equity mortgage runs anywhere from $10,000 to $100,000 and carries a note rate of 13% to 14%. The typical borrowers, according to Lieberman, are an individual or couple with “basically good income and credit”--no defaults or foreclosures--who have run up heavy credit card and other consumer debt during the last year or two.

“Their credit cards are eating them alive” at interest rates of 19% to 21% or higher, said Lieberman in an interview. Half to 60% of their monthly income has to go to payments on their cards and their existing mortgages. Millions of Americans fit this description today, if recent federal data on consumer debt loans and the personal bankruptcy boom are any guides.

What options do debt-drenched homeowners like this have? The answer offered by the growing ranks of no-equity lenders: Convert your credit card debts into mortgage debt, even if the resulting total mortgage balance exceeds the resale value of your real estate by a substantial amount. The rate on such a mortgage is lower than what you pay on your cards, and the 15- to 20-year payback terms are dramatically longer, thereby reducing your monthly payments.

Plus, at least for principal balances up to 100% of your home’s value, your interest payments may be deductible under federal tax law. Consumer debt interest payments, by contrast, are nondeductible.

Most negative-equity financings take the following basic form, according to Lieberman’s research:

The borrower’s existing first mortgage remains in place. A new second mortgage is added on top of the first loan to take the homeowner’s housing-related debt beyond the value of the property.

Say, for example, you own a home worth $100,000 and you’ve got a first mortgage or deed of trust of $85,000 at 9%. But you’ve also racked up $40,000 in combined charge card, furniture store and auto debts. You’ve never missed a mortgage payment, but you’re getting stretched to the breaking point by the 18% average interest rate on your consumer debts.

The no-equity remedy: You apply for a $40,000 125% loan-to-value financing deal at 13 1/2% for 20 years. The loan proceeds allow you to pay off all your card balances and the auto loan. And, thanks to the 20-year term and the 13 1/2% rate, your monthly payments on the $40,000 are more than $500 lower than what you were paying before.

What are the pros and cons of a negative-equity loan like this? Purely on a cash-flow basis, taking your mortgage debt to 125% of your home’s value may give you the breathing room you need. You can consolidate your nondeductible high-rate debt and convert it into lower-rate partly deductible mortgage debt.

But the potential downsides can’t be ignored. For starters, if a negative-equity loan doesn’t change your underlying behavioral problem--overconsumption of goods and services via credit cards--then eliminating your home equity stake may increase your probability of filing for bankruptcy.

Second, in an economic downturn, people with little or no equity end up in foreclosure far more frequently during recessions or layoffs than people with solid equity stakes.

Finally, before computing your expected after-tax interest savings from your new 125%-of-value mortgage, get competent tax advice. The Internal Revenue Service reportedly is concerned that some borrowers believe that all home mortgage interest on loans below $1 million is tax-deductible. Not so. You can’t deduct interest on any part of your mortgage debt that exceeds the fair market value of your house.

You can bet that as the popularity of negative-equity home mortgages soars in 1997, so will IRS audits of the borrowers who use them.

Distributed by the Washington Post Writers Group.