How Tapping Into Home Equity Is Like Pawning A Gold Necklace
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Bob Bradburn It has occurred to me that tapping into one’s home equity can be like pawning a gold necklace, television set, or other personal item with resale value. Both involve using collateral, either to borrow thousands of dollars through a home equity loan or home equity line of credit aka HELOC – or to borrow $50 for a very short period of time. I think it is interesting to compare and contrast these two types of loans.
Similarities between home equity-based loans and pawnshop loans:
- The borrower offers an item of value (a gold necklace or a $300,000 home) as collateral for the loan.
- Transaction fees (such as appraisal fees, insurance fees, and closing costs) are added to the loan amount.
- Items and homes are appraised to determine their value; the loan amount is dependent on but not necessarily equal to this value.
- The borrower often uses the money to fund an expense that is unrelated to the collateral. (For example, the money is used to pay a utility bill or tuition expenses, unlike a car loan in which the borrower gets a loan to finance the purchase of the car. According to the Consumer Bankers Association in a Bankrate.com article, 40% of HELOCs and 44% of home equity loans were used for debt consolidation with 23-25% used to fund home-improvement projects, back in 2002.)
- Transactions are subject to federal and/or state regulations.
- If payments are not made according to the terms of the loan agreement, the borrower forfeits his/her rights to the item. (Since the pawnshop already has the gold necklace, it simply retains possession of the item; the traditional bank's or mortgage company's arrangement is more complex and varies by state but basically the lender could have some legal rights to force the sale of the home via a foreclosure, receive proceeds from the sale of the home, or keep demanding repayment after the house is sold if the sale doesn't generate enough funds for repayment).
- As long as each loan is paid back, the something (home or necklace) can be used as collateral again and again.Â
Differences:
- The pawnshop customer relinquishes the personal item in order to obtain the loan but the home-equity borrower can still enjoy use of the home.
- The bank or mortgage company places a lien on the home to protect itself from losses; a lien provides the lienholder with the legal right to proceeds from the sale of the home.
- The home equity loan or HELOCÂ interest rate is typically much lower than the pawnshop interest rate (for example, 6% for a HELOC vs. 24% for a pawnshop loan).
- Interest paid on the home equity-based loan is tax deductible with certain restrictions.
- Homeowners may be able to obtain a high LTV (loan-to-value) and borrow more money than the collateral (home) is worth. Pawnshop owners make loans for less than the resale value.Â
A few months ago, a soon-to-be-out-of-work mortgage broker enlightened me on how some homeowners use home equity to meet financial goals such as saving for retirement or paying for a child’s college tuition. I was fascinated by the idea that lenders championed equity-based loans as a savvy financial strategy so for the sake of equal time, I am proposing that these loans are similar to pawning what may be one's most valuable asset.
Source on Pawnshops: Brain, Marshall. "How Pawnshops Work." 23 August 2001. HowStuffWorks.com. <http://money.howstuffworks.com/pawnshop.htm>  31 July 2008. Note: I have a client who used to manage a pawnshop so I also learned about the process from him as well.
Tagged: Consumer Affairs, Real Estate and Housing, banks, collateral, HELOC, home equity line of credit, home equity loan, mortgage companies, pawnshops
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You comments, while making certain quality points, are missing the bigger problem.
The problem is not where the money comes from (ie. Home Equity or Pawn Shop) the problem lies in what people use their home equity for.
If they use it to buy more assets (stocks, real estate, etc.) that have a return on investment greater than the cost of funds (loan interest rate)then there is no problem. In fact, this is how exponential wealth is created.
If, however, the funds are used to purchase depreciating goods such as electronics, automobiles, vacations etc. we end up with a serious wealth deterioration problem. The sad fact is that our consumer driven society makes the latter example much more common than the former.
Thanks for a good read!
-Tyler
If you take a relative low cost money source (HELOC or refinance) and invest it in something where your profits are more than the cost of the investment you're definitely making headway and should absolutely do it!
There are two kinds of people:
I see nothing wrong with the latter.
Here are the risk involved should you decide to tap into your home equity.
# The collateral is your house.
Yikes! You always knew that you could lose your house if you stopped paying your mortgage. But, your home equity loan is also a mortgage, so your house is at risk if you stop paying that, also. It is worth it for a fabulous new bathroom or some fancy landscaping?
# It can be a slippery slope.
If you use it to pay off credit card debt and you think you may be apt to repeat this, think again. Approximately 45% of all home equity loans are taken out to pay off credit card debt. Perhaps a credit card with a short-term super-low interest rate will be better for you to pay off the debt, as it won't tempt you to keep piling up the purchases.
# Bigger bills.
Obviously, taking out a loan for whatever reason is going to increase your monthly bills and give you less wiggle room. If you have the option of not taking on more debt, consider it.
Sam
Fix My Personal Finance
http://fixmypersonalfinance.com
I think it can be argued reasonably that tapping into equity can be wise and be foolish, depending on the uses. I hear so much about the wisdom of going into debt with one's home, I thought it would be nice to offer a counterpoint. And, depending on market conditions what seemed wise one day may not be as smart the next (that is when housing and market prices are falling so that the spread between investments and interest rate becomes very narrow, and a homeowner owes more on the house than he/she has in equity). Savings and investments can also be used as collateral to secure loans; or one could borrow against the home equity and have an investment account set aside to pay it off immediately if necessary.
I love our HELOC (despite it freezing due to economy junkess), as it helped us avoid PMI and get into our house with as little down as possible - and yes, this is def. BAD for some people - but it works for us perfectly, and is our "2nd mortgage". AND, since it was variable, it's dropped over 4% since last year! so we can now pay down more of our mortgage if we wanted, or re-invest it. I like the latter ;)
The government subsidizes *all* my borrowing if I use a HELOC rather than a consumer loan.
I have paid off my mortgage, but the HELOC is there to take advantage of the equity in the house.
It offers the lowest rate at which a consumer can borrow, and the interest is tax-deductible.
Why would a homeowner borrow any other way?
To me the question is not always "how should I borrow" but can be "should I borrow"? For someone who has paid off the first mortgage, the HELOC will then (typically) place a first lien against the home so if you default on the loan, then you lose your house. So, theoretically, you could borrow $20,000 but put a $300,000 asset at risk.
It's true (too true IMHO) that the US government has encouraged home equity-based lending by giving a tax break for mortgage interest. But if your mortgage interest doesn't exceed the standard deduction, then this type of interest does not really benefit cash flow. In that scenario, you are benefiting from a lower interest rate (most likely) but not receiving a tax benefit. Obviously, each case is different.
The lender might foreclose and sell your house at auction, but you as owner get the proceeds after their $20,000 lien (plus court costs) is paid.
Court costs are often limited by law - here if I foreclose on omeone I can only add $1500 maxiumum onto the lien for court costs.
@Taylor:
You raised an interesting thought about the use of home equity loans for investing vs conspicuous consumption. However, I don't agree with your implication that the use of such loans as leverage for investments is viable.
While the idea is well-intentioned, it does put your home at risk. As a real-life example of how an approach can turn out poorly, consider this recent news item where an "Extreme Makeover" family lost their home, after using their house as collateral to fund a construction business:
http://latimesblogs.latimes.com/laland/2008/07/extreme-home-fo.html
Randy@FiscalZen
That "Extreme Makeover" family apparently got a $450,000 loan for what is now a $350,000 house.
Even that's a stretch since it is surrounded by $150,000 homes.
I think they got a pretty good deal out of the lender, even if they did blow the proceeds.
That bank loan amounts could be so close to the equity amount or above (though perfectly reasonable in many cases but perhaps not in the Extreme case) whereas pawnshop loans were much lower compared to the collateral value is one thing that stood out to me. The pawnshop owners seemed to have a solid, hands-on grasp of the value of certain items, understanding of how economic conditions increased flow of merchandise into the shop while lowering demand, etc. Being directly accountable for the loan may make him/her more attuned to judging the value of the collateral.
I agree with most of the posters. If the borrowing against home equtiy is used to buy an asset (ie something that puts money in your pocket every month, like a piece of rental property) then that is a wise use of the equity. However, few people actually do this.
To use home equity to "consolodate bills" (ie pay for your car, cloths and ocmputer) only digs the consumer further into debt. Very few of them alter their spending habits, but rather they just max out the credit cards again. The lifestyle cycle of borrowing and refinancing consumer items a dangereous trend.
What is needed is some common sense finanical education!!
Sometimes, doing things the hard way (like learning to spend less and work out of debit slowly) is better than a quick fix that a home equity loan might provide.
I agree that using a home equity loan to purchase an income-producing investment which covers the loan cost and yeilds more above that in income each month makes sense, however this is frequently not what people do- they just use the money for instant gratification.
-Suz