“The more things change, the more they stay the same.”
Although the global economy is cyclical, we as consumers have the ability to control our outcomes by learning from the past. Unfortunately, a recent rise in home equity borrowing shows that, for better or worse, consumers are once again feeling more comfortable using their homes as leverage for their finances. One particularly frightening type of borrowing on the rise is in piggyback mortgages:
“A type of mortgage where a second mortgage or home equity loan is taken out by a borrower at the same time the first mortgage is started or refinanced. Piggyback mortgages are frequently used to lower the loan-to-value ratio (LTV) of a first position mortgage to under 80%, thereby eliminating the need for private mortgage insurance (PMI).” – Investopedia
You might wonder why this is a problem – PMI is undoubtedly an expense that should be avoided and many homeowners choose home ownership over renting so they can have the flexibility to do this kind of borrowing. But using your home as collateral for any type of borrowing is a risky gamble – and one that could lead to underwater mortgages or, worse, loss of the home. Below we’ll talk about this latest trend and an alternative means to achieving your homeownership dreams.
Homeowners Using Their Homes for Financial Leverage
A recent article in The Wall Street Journal goes into great detail about the latest trend in borrowing and it’s happening now:
“Borrowers took out about 230,200 home-equity lines of credit in the first quarter, up 9% from a year prior, letting them tap up to $23.4 billion, the highest quarterly amount since 2008. The average credit line in March was $100,207, up 4% from a year earlier and the highest since 2008, according to credit-reporting company Equifax.
Lenders are luring homeowners by charging lower interest. Home-equity lines of credit, which are commonly known as Helocs and which account for most home-equity lending, had an average rate of 5.01% in June, down from 5.16% a year earlier, according to mortgage-information website HSH.com. Rates on new home-equity loans also have fallen.
The most common reason borrowers give for taking out loans and lines of credit is to pay for renovations. Others use them to cover emergency expenses.”
Note the year mentioned in the statistic above: 2008. As you may recall, that was the year the US economy came grinding to a halt and many people faced foreclosures in a trend that would last for years to come. Due to this, lenders became more conservative and borrowers began to rethink the value of home ownership altogether.
Our economy has since stabilized but many consumers are still dealing with the fallout from 2008. For those struggling to repay debt acquired during that time (and dealing with job loss or lower pay on top of it), borrowing against home equity can be a cheaper way to pay the debt off, thanks to lower interest rates. (Although it doesn’t come without risk – defaulting on payments can mean losing your home.) But borrowing against the home to fund an emergency savings account? Or doing so to have more money for a new home? That’s a gamble that might not be worth taking.
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How Homeowners Use Piggyback Mortgages to Buy Their Next Home
Perhaps one of the most alarming things about this latest trend is the rise in what’s called a “piggyback mortgage”. The Wall Street Journal explains how it works:
“Some home buyers are using loans and lines of credit to buy new homes. By combining a mortgage with a line of credit, for example—an arrangement known as a piggyback mortgage—borrowers can avoid fees associated with low down payments and may be able to afford a more expensive home.
But tapping loans and lines of credit can reduce a homeowner’s equity and present significant risks. Perhaps the greatest danger is that a drop in housing prices could leave homeowners owing more money on their properties than they would be able to sell them for in a pinch. Normally, the down payment and any paid-off principal provide a cushion.”
This isn’t the only risk that can come along with a piggyback mortgages. A home equity line of credit (HELOC) is revolving debt, like a credit card. That means the money is there if you need it, but you only pay interest on what you borrow. And, like a credit card, the interest rate is variable. The biggest problem with this is that even if your current budget can handle the monthly payments, those payments can increase at any time if the interest rate does. That potential increase in interest adds a scary unpredictability to your budget.
Use Cash As Leverage Instead
As someone who isn’t yet a homeowner, I can say my expertise on home ownership only goes as far as my rabid love for nearly every show on HGTV. But something I love less is seeing buyers on TV say homes are only worth buying if they have granite countertops and stainless steel appliances…. Or saying updates “must” be done before they can move in, even though the updates are usually to make a home more in style than functional.
Perhaps shows like this paint a picture that globalize our need to keep up with the Joneses. It’s no longer about what our neighbors and friends have. When I see homeowners shop for a 3,000 square foot home in Texas, my 500 square foot apartment in California (which seemed perfectly nice to me before) pales in comparison. (And let’s not even talk about how I’m probably paying more on rent than the mortgage of those homes would cost…)
So when I – and many others – watch these shows, is it all in good fun? Or does it plant a seed in our heads that we need larger homes and nicer finishes? And if it does plant the seed, that’s pretty dangerous considering the fact that things like piggyback mortgages can leave consumers underwater on their homes faster than they realize what’s happening.
In the The Wall Street Journal article, the author suggests using home equity loans (which come with a fixed amount, fixed interest rate, and fixed payoff date.) In comparison to the variable interest rates of a HELOC, this seems like a better choice. However, I’d argue that the best choice is… cash.
To truly protect your finances, wait until you have a down payment saved up before even looking at new homes. An emergency fund would be useful as well, given the unknown costs that can quickly add up when purchasing and moving into a new home. Yes, it can certainly slow down the process of finding a new home (or limit the inventory you can choose from), but it can also mean peace of mind in knowing you have less chance of getting in over your head in debt. Mortgages may be a tool for your finances, but that tool can only work if used wisely.
Image Credit: Nana B Agyei