Financial Experts Debate 125 Percent Loan Product

Journal Record, (Oklahoma City), Jul 15, 1997 by Jay Romano N.Y. Times News Service

 

 

NEW YORK -- Responding to the seemingly insatiable demand by borrowers for ever more exotic forms of credit, some aggressive lenders have brought to market a rather unconventional mortgage product: the 125 percent loan.

 

With such a loan, homeowners -- even those with less-than- pristine credit -- may borrow up to 125 percent of the market value of their homes by pledging collateral that doesn't exist.

 

Lenders who make such loans say they are effective credit tools that can be used by homeowners to raise cash for unexpected expenditures, get out from under high-interest credit-card debt or pay for home improvements that will in turn increase the owner's equity. Some real estate experts say, however, that such loans are not only more expensive than a traditional home-equity loan, but that homeowners who borrow against nonexistent equity could find themselves stuck with the loans for many years without the ability to refinance them. Moreover, tax experts say that in some cases a significant portion of the interest on such loans may not be tax deductible. "We are entering a dangerous area here," said Neil Bader, chief executive of Skyscraper Mortgage Co., a Manhattan mortgage broker. Bader's concerns center around the apparent convergence of home- equity mortgages with "hard money" loans -- the kind of loan traditionally obtained by high-risk borrowers willing to pay higher- than-average interest rates on loans. Increasing numbers of consumers, Bader said, seem to be borrowing increasing amounts of money simply because lenders are so anxious to let them do it. That can pose a serious problem, he said, because borrowers who overextend themselves when the economy is thriving have little room to maneuver if things go downhill. And the stakes are highest when the family home is at stake. "We're now seeing a boom in hard lending against home equity," Bader said. "And for most people, that kind of loan just doesn't make sense." The way a 125 percent loan works is fairly simple. A homeowner with a $150,000 mortgage balance on a house worth $200,000, for example, could take out an "equity loan" of up to $100,000, even though the actual equity in the home is only $50,000. That would result in a total indebtedness of $250,000 on the $200,000 property. Keith T. Gumbinger, vice president of HSH Associates, a financial publisher based in Butler, N.J., said the loans were targeted for homeowners wishing to consolidate debt or improve the value of a dwelling through major renovations. In theory, he added, the loans are designed for only the highest quality borrowers. In practice, however, those with minor credit problems often are likely to seek them. "The interest rates on these loans can range as high as 14 percent," said Gumbinger. He pointed out that standard home-equity loans -- those that require a 10 to 20 percent equity "cushion" to protect the lender (and the borrower) from reductions in value -- are now being offered at interest rates around 8.5 percent. There is another disadvantage associated with borrowing against equity that really isn't there. By definition, Gumbinger explained, a 125 percent loan results in "negative equity" because the total indebtedness exceeds the market value of the property. And that, he said, makes it nearly impossible for the homeowner to refinance to a conventional loan at a later date because conventional lenders typically limit their loans to 80 percent or 90 percent of market value. As a practical matter, he said, it would take a considerable amount of time -- or a considerable amount of appreciation in property value -- for a homeowner to get back to an acceptable "positive equity" position. Mark Eisenson, the owner of Good Advice Press, a financial publisher in Elizaville, N.Y., said that on a 20-year, $100,000 loan at 14 percent interest, it would take 186 months -- or 15 1/2 years - - to pay off half the principal balance of the loan. If that isn't discouraging enough, Eisenson said, consider this: After making those 186 payments -- at $1,243 a month -- the remaining balance on the mortgage will be about $50,000, while the total interest paid will amount to more than $180,000. It's a good thing all that interest is tax deductible, right? "It seems pretty clear that only half the interest paid would be deductible," said Joel E. Miller, a Queens tax lawyer. The deductibility of interest on a principal residence, Miller explained, is limited to interest on loans used to acquire the property -- known as acquisition borrowing -- up to $1 million, and on post-acquisition loans secured by equity in the home -- known as equity borrowing -- up to $100,000. So, even though the equity loan in the above example falls within the $100,000 limitation, only half the interest is tax deductible because only half of the loan is actually secured by equity. Notwithstanding that, and notwithstanding the higher interest rates, and notwithstanding the potential for living for years in an equity vacuum, many homeowners find it difficult to resist the lure of converting high credit card balances carrying 20 percent interest into a home-equity loan at 13 or 14 percent. "To a consumer, it means they have more options," said Jonathan S. Hornblass, publisher of Home Equity News, a financial newsletter based in Manhattan. "In the past, homeowners who had equity of 20 percent or less were pretty much done for in terms of being able to borrow against their homes. But now I'm hearing rumors of lenders who will go as high as 150 percent of equity. "And while that may not be a problem as long as the value of a home is appreciating, if we get into a declining market, people will really start ducking their heads." For now, however, 125 percent loans appear to have struck a chord. "This is a very popular product," said David Levy, a mortgage broker at Park Place Home Mortgage Corp. in Manhattan, which offers 125 percent loans. "Particularly with people who have bought houses with minimal down payments over the last two years or so." Levy said that 125 percent loans were typically more expensive to obtain than standard home equity loans. In addition to normal closing costs -- which can be a few thousand dollars -- borrowers may expect to pay anywhere from 3 to 6 points for such a loan -- with each point being 1 percent of the amount being borrowed. On the other hand, Levy said, 125 percent loans are easier to qualify for. In most cases, he said, minor blemishes on a person's credit record will not be a problem. Moreover, he said, a potential borrower's allowable income-to-debt ratio -- which is used to gauge the borrower's ability to carry the additional expense of the loan -- is less stringent. "The underwriting criteria are actually more flexible," Levy said. "They allow more dinks on your credit and a more narrow spread between what you make and what you pay out." And that is just what concerns Bader of Skyscraper Mortgage. "The person who couldn't qualify for an ordinary home equity loan at 8 percent is now borrowing even more money at 14 percent," Bader said, adding that anyone thinking about taking out such a loan should contemplate the following: "What happens if you want to sell your property, and you find that what you owe is more than what your property is worth?"

 

Copyright 1997

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