"The Home Equity Trap"

Posted by: Peter Coy on October 18, 2005

How’s this for a scary scenario?

On paper, you’re reasonably well off. You don’t own many stocks or bonds, but your house is worth a lot more than you paid for it. You figure you’ll sell it when you retire, move into a cheap condo somewhere, and live off your housing equity.

Then you get laid off. Your stocks and bonds carry you for only a couple of months. Next you max out your credit cards.

Well, you figure, you still have that housing wealth. So you go to your local bank for a cash-out refi. But because you’re out of work and have maxed out your credit cards, your FICO score looks bad. The bank turns you down.

Humiliated, you go to a subprime lender, who gives you the money you need but at an extremely high interest rate. Or you sell the house and move out of town, tail between your legs.

Your problem: Not a lack of wealth, but a lack of liquidity. You couldn’t easily get money when you needed it.

This can happen. It does happen. Most middle-income Americans have far too much of their housing wealth tied up in their homes. According to the Federal Reserve’s 2001 Survey of Consumer Finances, middle-income families (40th percentile to 59th percentile, to be exact) 67% owned their primary residence, but only 16% directly owned stocks.

I came across some interesting testimony on this topic by Anthony Yezer, an economics professor at George Washington University. Last year he told a House subcommittee about what he calls “the home equity trap”—where people whose income abruptly drops can spiral downward because too much of their wealth is locked in their homes. Go to page 5 of this link.

Reader Comments

Lord

October 19, 2005 2:07 PM

This is why an equity line of credit is recommended while still working. A 6% yield on mortgage paydowns vs. a 4% yield on bonds or stock earnings yield of 5% is still better. Diversification in this instance is overrated unless price declines would significantly affect your equity.

greg

October 19, 2005 3:22 PM

You haven't even mentioned what happens when house values drop by 30-50% and most people are underwater!

Taylor

October 19, 2005 5:31 PM

Thursday, April 28, 2005
Housing Market in California

4/28/05
OK! For all of us that still live in the real world, it’s time to talk realistically. The average person’s salary in California is around $40,000/year, based on info from the 2004 Occupational Employment Statistics (OES) Survey. For those who don’t know, the average salary correlates to the middle class income. Now, the average sales price for a home in California is $495,000 as of today (by the way that’s half-a-million for all you lay-people). HUH???? At the current phenomenal rate of just 5.85% interest on a 30 year loan, with property taxes included, zero money down and an adjustable rate mortgage (ARM) after 10 years, the average Californian pays a conservative $3200/mo for his 3 bedroom shack in beautiful Carson. Think about it, at the published OES average wages per year, the average Californian makes about $3,330/mo before deductions. If we subtract a really conservative 10% off of the gross income for taxes and social security, we leave the average Californian with $3000 and no money to pay his mortgage. That automatically eliminates about 50% of the state from buying homes. We might still say there’s no ridiculous bubbly type bubble in California, so let’s examine who can afford these irrationally overpriced properties. Most intelligent people know that a mortgage should take up no more than 1/3 of your monthly take home pay. We’ve already shown that the average Californian’s mortgage is 110% of his monthly take-home. Is everybody ready for some Math 101? In order to figure out the amount of take-home pay we would need to afford this mortgage, we simply multiply the monthly mortgage calculated above of $3200 by 3. The needed take-home income now becomes $9600/mo, that’s a gross income of $145,000/year. Some of you will now say, “Well, if I made $9600/mo take-home I could afford a $1,000,000 home”, which is exactly what is fueling house-inflation mania in California…people living way beyond their means. Since most of us don’t use the 1/3 rule, I will reconfigure the monthly income, such that ½ of our virtual-income goes to the mortgage. Using ½ of our take-home pay for the mortgage, we would need $6400/mo take-home. Lest we forget, Uncle Sam likes his money too. So adding back in our extremely conservative 10% for taxes and social security, we would need to gross $7100/mo. This equates to $85,000/year (for all of us who say, well I make $80,000 or $90,000 with my wife’s salary, that’s fine until one of us loses our job, or even worse we both do). More importantly, less than 4% of Californians fall into this group. So that eliminates the other 46% of the state from either moving into another home or buying a first time home in the current market. There is a real problem, and it’s deeper than housing bubbles or crashing stock markets. The problem lies in the fact that Californians always want the nicer car, the nicer house, the nicer boat, the nicer vacation home. For a vast majority of people living in California, it’s all about numero uno. Californians are not the only ones, most Americans are never happy unless they’re spending money on themselves. We’re always spending money we don’t have to keep up with the Jones down the street. But what happens when the interest rates go back up again, which they will, or the housing market goes through a quarter or two with almost no sales, which it will, or the dollar keeps falling in value, which it will, or buyers are pushed so far out of the market they can’t even dream of affording a decent shack…let alone a decent house, which they already can’t (they just don’t know it yet). That’s right friends and neighbors the housing market will crash faster than a 747 jumbo jet with both wings missing and the cabin on fire. Worse yet, it will bring the entire economy with it. It doesn’t take a PhD in economics to see that we’re in a horrible pandemonium, and if it doesn’t stop soon we’re going to be worrying about a lot more than the fact that our home has depreciated 50% or more. We’re going to be worrying about which bankruptcy lawyer to go to. So, you may still say there’s no housing bubble…well, if you believe that, I have some beachfront property in Burbank to sell you. Homeowners, builders, realtors, buyers and sellers believe there’s no bubble in today’s market, because they have homes to protect. But there is a bubble, and it’s getting heavier over California and it's ready to pop which will deliver another debilitating blow to the economy. Conclusion: buying a home in California is for the birds (or bird-brained).

Peter Coy

October 20, 2005 10:19 AM

I agree with what Lord said yesterday. Arranging a home equity line of credit is a smart way to increase your liquidity and make sure you won't fall behind on bills if you get sick or get fired. Two keys: Arrange the line now, before you need it. And don't use the equity in your home for routine expenses.

AnonymousChicago

October 23, 2005 2:19 PM

To Taylor: Your math is correct, sir, and when the bough breaks it's going to break really hard. I'm living in lovely Chicago where the price for a condo is 'ridiculous'. The city and the developers are pushing renters into condos through conversion and attractive mortgages. Already in my neighborhood I see "for sale" signs in every block where there were condo conversions & new bldgs less than 5 years ago. Owners are cashing out -- NOW! while they can.

Fran

October 30, 2006 3:15 PM

My husband died suddenly in our home. He had taken out a line of equity on it, in the form of a credit card. after his death, I went into a deep depression,on medication and started going to the casinos nearby.I used the card there for time to spend away from the house. After a while the card maxed out and during that time the bank never called once; not until it maxed out at 41,000 against the house. now the finance charges are all that I can pay each month. Are any of the finance charges going towards the balance? The bill shows that the balance remains the same every month.My husband had a balloon rate and a 10 year full payment due contract.I have learned all this after comming off my medication, which I cannot blame this on. It is all my own fault.Should I file bankruptsy,or let them foreclose.
Thank You, Fran

Steven James

November 7, 2006 1:43 AM

Well, this situation can be avoided if people know the basics of a Home Equity Loan.

Regards,

Steven.

michelle

January 6, 2007 3:54 PM

We have lost our job but now my husband just went back to work, we are 3 months behind in our mortgage. I want to know if foreclosure or bankrupsy is better?? The line of work we are means my husbands credit will affect his job. So what do we do bankrupsy or foreclosure? Help!

joe

October 28, 2007 11:36 AM

NEED HELP i purchased my home in july of 07 for $338,000 with 5% down and a 5 year arm with a 80/20, i would like to refianance already, is this a smart thing to do and when i refinance can i take money out to fix some things on my house ie(new siding) the house when i purchased it was a fixer upper and already i pumped about $50.000 into it ie, made living room bigger and all new electic through out and added duckless central air, so i think the house should be worth more then what i paid for it already

vijendra

January 20, 2009 4:59 PM

what do you need to know about home loans and mortgages? You need to know the risk behind them. You need to know what the basic concepts of a loan are, like interest rates, tenure and the main mortgage formats and what they mean to you.
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vijendra jain
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Home Loans - Home Loans

Mark

February 21, 2009 2:06 AM

IF YOU'VE EVER watched television, then you've seen an ad (or more like half a dozen) for home-equity loans that exceed the equity you have in your home. And, if you're struggling with credit-card debt and other personal loans, you might have considered one. You can trust Dan Marino, right? That former Miami Dolphins star who has been flogging such loans for FirstPlus Financial. Or can't you?
The truth is, these loans, which are basically home-equity loans with unsecured personal loans tagged onto them, are a lousy deal. Their high interest rates and outrageous fees will kill you.

===========================

Home Loans

Mark

February 21, 2009 2:07 AM

IF YOU'VE EVER watched television, then you've seen an ad (or more like half a dozen) for home-equity loans that exceed the equity you have in your home. And, if you're struggling with credit-card debt and other personal loans, you might have considered one. You can trust Dan Marino, right? That former Miami Dolphins star who has been flogging such loans for FirstPlus Financial. Or can't you?
The truth is, these loans, which are basically home-equity loans with unsecured personal loans tagged onto them, are a lousy deal. Their high interest rates and outrageous fees will kill you.

===========================

Mark

Home Loans

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About

BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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