Thursday, July 3, 2008

Changing Climate of Home Equity Borrowing [By: Tom Kerr ]

Trends in home equity borrowing during the past two decades have been dramatic; within the past two years, home equity loans have been on a virtual roller coaster ride. Just a year ago, homeowners were relying on them as ATM machines. Now, banks are yanking them from their product menus.

Back in 1986, the IRS tax rules were rewritten to create deductions for homeowners that were similar to those enjoyed by taxpayers who owned income-producing property. The change precipitated a real estate crash, because tax advisors recommended that clients dump their rental properties. It also launched a new trend in home equity borrowing, because consumers could enjoy a deduction for interest paid on home equity loans.

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Enjoying home equity tax breaks
Although there are some restrictions related to the size of the deductions-equity loans used for home improvements provide potentially higher deductions than those spent on a new car, for example-home equity tax incentives are a big plus. Once the IRS offered the tax perks, taxpayers began to shift massive amounts of their debt into equity loans, and away from other products like credit cards and auto loans. They also began using their equity more freely, especially during bullish real estate market cycles when property values climbed quickly, creating increased equity on paper.

Swelling home equity riches
The clearest example of instant equity was during the most recent rise in home prices. Housing inflation swelled, creating the so-called bubble. In some regions of the U.S., prices doubled within a matter of months. As market values rose, this contributed equity to the underlying properties. If you buy a home for $150,000 and owe $100,000 on the mortgage, for example, you enjoy $50,000 worth of equity. But if the value of your home suddenly leaps to $300,000, you automatically and effortlessly have $200,000 in equity-a fourfold increase. This is what led many ordinary homeowners to catapult into paper wealth, and they eagerly pulled that cash value from their homes through various equity loan products. A 2006 study by the Pew Research Center revealed that the majority of personal wealth claimed by homeowners was in the form of real estate equity. Twenty percent of all homeowners had an outstanding equity loan in that year, and banks promoted such instruments aggressively by offering lower rates and higher loan amounts.

Collapsing bubble
Then, the bubble burst, housing prices plunged, and the source of paper wealth vanished, leaving many borrowers overextended and owing more than their homes were actually worth. Lenders got left holding the bag-which often happened to be empty-and now they're rapidly reeling in their lines of credit in an effort to avoid further losses from loan defaults. During 2008, many major lenders eliminated or severely curtailed home equity lines of credit, lowered the lending ratios on second mortgages, and increased property appraisal, income, and credit score requirements.

The easy money equity party is officially over. The real estate ATM machine has finally been unplugged.

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