Use it? Lose it? Soft economy, easy money signal home owners to guard equity use

By Broderick Perkins
DeadlineNews.Com

MORE and more households are shifting consumer debt to their mortgages at a time when home values are flat or falling -- a personal financial move that could be disastrous.

The strategy is driven by increasingly easy access to equity-based loans that provide households with certain financial benefits, but it could reduce your equity or cost you your home at a time when you need it most.

"Lending is too easy and the chance for making the mistake of a lifetime is out there for some people. Anyone who is not always certain about their employment, they need to be cautious (about using home equity) in the emerging market," said Ken Willis, president of the Upland, CA-based League of California Homeowners.

The average U.S. household now owes 107 percent of its annual income, with most of the recent increase due to a shift in debt from installment and credit cards to mortgage debt, according to Standard & Poors recent study, "How Much Could A U.S. Recession Hurt Credit Card Losses" a report that has particular implications for Silicon Valley.

"The doubling of the stock market from 1995 through 1999 convinced Americans that they were rich enough to spend more. Since the stock market was doing our saving for us, Americans felt comfortable in spending more than they earned. Trading up homes increased mortgage debt, as did the increase in the home ownership rate. In addition, many Americans took advantage of low mortgage rates and the deductibility of mortgage debt by rolling consumer credit into their mortgage," the S&P report says.

Today's lack luster economy may not generate the level of wealth to which many households have grown accustomed. If home owners haven't adjusted their savings, spending and borrowing habits accordingly, tough times could be ahead.

"With the economy decelerating, employment growth will slow sharply. The unemployment rate is expected to rise above 5 percent later this year, and the layoffs will impact household ability to pay," says the report.

Home owners should shore up the equity they have and use equity wisely when tapping it is necessary.

Here's how.

Plugging the equity drain

For many, a home is their most valuable asset. It's an investment that, over time, virtually always yields a return that out paces inflation.

Residential real estate holdings, including first second homes and investment property accounts for 63.3 percent of household wealth according to Federal Reserve Board's "Recent Changes in U.S. Family Finances: The 1998 Survey of Consumer Finances".

The numbers could be higher in Silicon Valley.

In just five years, Santa Clara County homes have appreciated by about 50 percent, according to R.E. InfoLink data mined by Richard Calhoun, owner broker of Creekside Realty in San Jose.

Protecting that increased value is paramount.

"Make your mortgage payment the first priority in paying your bills. If you have suffered a decrease in income due to a layoff, let your lender know immediately. If you fall behind in your payments, maintain contact with your lender. Do not bury your head in the sand and avoid the phone calls from your lender, says Pam Foley, broker-owner of Campbell-based E. F. Foley & Co., Inc.

In the past 10 years, numerous Silicon Valley households have enjoyed home values that have increased by as much as 100 percent, but because of the cooler market, they could be about to lose some of that value.

Some experts say it may not be a bad idea to squirrel away equity today for a rainy day. Even if you don't need to use the cash now, pulling out and investing what you may need later could save it from a declining market. Should rates rise -- an unlikely event earlier this year -- you could pay more to borrow less.

"As prices drop, appraisals drop. If the owner waits for lower interest rates, he or she may be prevented from borrowing because of the lack of equity after the prices fall," said Calhoun.

Ceci Ellis, a real estate agent with Taylor Properties in Palo Alto says if you don't need to use the equity, it may be a better idea to move the equity to a larger move up or second home. Sell or hold onto your original home as an investment property.

"The less expensive (or starter homes) are selling more easily in this recessionary economy than the more expensive homes. Those larger, more expensive homes are in much less demand and should be good buys now, "Ellis said.

If you are staying put, debt consolidation can be a smart use of your equity, provided you are disciplined enough not to obtain more credit while the consolidation equity loan is outstanding. Consolidation under the home equity umbrella will provide cheaper credit and it will give your borrowing the tax shelter of interest deduction.

"Now more than ever, people should be taking a hard look at their monthly spending with an eye towards trimming the fat and getting rid of high cost debt such as consumer loans," says personal finance advisor, Eric Tyson, also author of "Mortgages For Dummies" (Hungry Minds, $16.99).

The Consumer Federation of America says another wise use of home equity is for capital improvements -- home improvements, education and new business financing -- loans that generate a return on your money.

Home equity improvements

One of the best returns on your equity money is money spent on your home.

Home owners who were also stock market investors who enjoyed the "wealth effect" of sudden riches, decided long before the stock market and real estate market turned to cash in some of their earnings on home improvements.

Not only did their returns escape the clutches of Wall Street's bear market, they helped boost the value of their home

Rather than cash out his home's equity, Gabe Gross last year used $30,000 in stock market earnings to install new windows, a deck, sunroom and hot tub in his Redwood City, CA triplex.

"I rent out two units and live in one, so I can deduct the improvements as a business expense even though I won't get the home equity loan's interest deduction," said Gross, a marketing consultant.

The best home improvements, of course, are those that give you the most return for the money -- kitchen, bath and master suite re-dos, but also those that add square footage.

"Anything that makes a home more energy efficient, at this point in time, would be a great long-term investment too," said Ellis.

The same applies to seismic strengthening -- retrofitting your home to better withstand an earthquake.

Whatever work you do, this is no time to cut corners. Protect your home improvement investment with proper permits, and solid, skilled, professional work.

Using cheap credit

If you decide to use your equity, you'll benefit most from paying the least for credit.

Don't panic shop. The plethora of loan programs demands that you take ample time to shop around for a loan that's best for you. Predatory lenders won't hesitate to bum-rush you with a loan you can't afford. Sign for a loan that's too expensive and you'll cut into any financial benefits you hoped to enjoy.

Most borrowers shop for loans with a mortgage broker, because they have access to many more loans than an individual bank or lender.

Brokers handle 70 percent or more of all mortgages and even though they can examine many loans, they do not always work in your best interests.

"When you walk into a broker's office, the broker is there to try to get the business. There is nothing wrong with that. Many brokers will give you the straight up, but Company A is not going to be harping about Company B," says Exeter, NH-based Jeffrey A. Arndt, who operates MortgageExam.com.

Like White Bear Township, MN-based mortgage expert, Roger Harrington and Wayne, PA-based Jack Guttentag's "Upfront Mortgage Broker" (UMB) program, MortgageExam.com is among a growing number of mortgage counselors who, for a fee, will help anyone compare mortgage programs, read the small print and examine all the costs, much as a paid financial counselor advises you on investments.

"We were tired of being called loan sharks and bandits. If we disclose up front and explain how things work, there will be fewer problems at closing and everyone will have fewer surprises," said Jeff Jaye, a UMB with Monument Mortgage in San Ramon.

Insuring your equity

Even if you don't use your equity, move it to another home or improve on it, you've got to make sure it's adequately protected by shoring up the replacement cost provision of your home owners insurance policy.

Approximately 70 percent of all homes in the United States are underinsured, and of those, 70 percent are underinsured by 30 percent, according to Princeton, NJ-based Marshall & Swift, a building cost information provider.

Most homeowners insure their homes based only on their lender's requirements -- frequently only enough to cover their mortgage balance. Others forget to increase coverage after home improvements increase the cost to replace their home.

"In a softer economy it is important to remember that your home is still usually your largest asset. It's important to treat that asset accordingly. Insurance is still a reasonably small price to pay for security," said John King, a real estate agent with Alhouse King Realty, Inc. in Palo Alto.

Published Monday, April 16, 2001, 12:00 PM for San Jose Magazine