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HOME EQUITY/ HOME EQUITY LINE OF CREDIT
The Home-Equity Loan: What It Is And How It Works?
A home-equity loan, also known as a second mortgage, lets homeowners borrow money by leveraging the equity in their homes
The Home-Equity Loan: What It Is And How It Works

A home-equity loan, also known as a second mortgage,
lets homeowners borrow money by leveraging the equity
in their homes. Home-equity loans exploded in popularity
in 1996 as they provided a way for consumers to
somewhat circumvent that year's tax changes, which
eliminated deductions for the interest on most consumer
purchases. With a home-equity loan, homeowners can
borrow up to $100,000 and still deduct all of the interest
when they file their tax returns. Here we go over how
these loans work and how they may pose both benefits
and pitfalls.


Two Types of Home-Equity Loans
Home equity loans come in two varieties - fixed-rate loans
and lines of credit - and both types are available with
terms that generally range from five to 15 years. Another
similarity is that both types of loans must be repaid in full
if the home on which they are borrowed is sold.

Fixed-Rate Loans
Fixed-rate loan provide a single, lump-sum payment to the
borrower, which is repaid over a set period of time at an
agreed-upon interest rate. The payment and interest rate
remain the same over the lifetime of the loan.

Home-Equity Line of Credit
A home-equity line of credit (HELOC) is a variable-rate
loan that works much like a credit card and, in fact,
sometimes comes with one. Borrowers are pre-approved
for a certain spending limit and can withdraw money
when they need it via a credit card or special checks.
Monthly payments vary based on the amount of money
borrowed and the current interest rate. Like fixed-rate
loans, the HELOC has a set term. When the end of the
term is reached, the outstanding loan amount must be
repaid in full.

Benefits for Consumers
Home-equity loans provide an easy source of cash. The
interest rate on a home-equity loan - although higher than
that of a first mortgage - is much lower than on credit
cards and other consumer loans. As such, the number-
one reason consumers borrow against the value of their
homes via a fixed-rate home equity loan is to pay off
credit card balances (according to bankrate.com).
Interest paid on a home-equity loan is also tax deductible,
as we noted earlier. So, by consolidating debt with the
home-equity loan, consumers get a single payment, a
lower interest rate and tax benefits.

Benefits for Lenders
Home-equity loans are a dream come true for a lender,
who, after earning interest and fees on the borrower's
initial mortgage, earns even more interest and fees. If the
borrower defaults, the lender gets to keep all the money
earned on the initial mortgage and all the money earned
on the home-equity loan; plus the lender gets to
repossess the property, sell it again and restart the cycle
with the next borrower. From a business-model
perspective, it's tough to think of a more attractive
arrangement.
The Right Way to Use a Home-Equity Loan

Home-equity loans can be valuable tools for responsible borrowers. If you have a
steady, reliable source of income and know that you will be able to repay the loan, its
low interest rate and tax deductibility of paid interest makes it a sensible alternative.
Fixed-rate home-equity loans can help cover the cost of a single, large purchase,
such a new roof on your home or an unexpected medical bill. And the HELOC
provides a convenient way to cover short-term, recurring costs, such as the
quarterly tuition for a four-year degree at a college.

Recognizing Pitfalls The main pitfall associated with home-equity loans is that they
sometimes seem to be an easy solution for a borrower who may have fallen into a
perpetual cycle of spending, borrowing, spending and sinking deeper into debt.
Unfortunately, this scenario is so common the lenders have a term for it: reloading,
which is basically the habit of taking a loan in order to pay off existing debt and free
up additional credit, which the borrower then uses to make additional purchases.

Reloading leads to a spiraling cycle of debt that often convinces borrowers to turn to
home-equity loans offering an amount worth 125% of the equity in the borrower's
house. This type of loan often comes with higher fees because, as the borrower has
taken out more money than the house is worth, the loan is not secured by collateral.
Furthermore, the interest paid on the portion of the loan that is above the value of the
home is not tax deductible.



If you are contemplating a loan that is worth more than your home, it might be time for
a reality check. Were you unable to live within your means when you owed only
100% of the value of your home? If so, it will likely be unrealistic to expect that you'll
be better off when you increase your debt by 25%, plus interest and fees. This could
become a slippery slope to bankruptcy.

Another pitfall may arise when homeowners take out a home-equity loan to finance
home improvements. While remodeling the kitchen or bathroom generally adds value
to a house, improvements such as a swimming pool may be worth more in the eyes
of the homeowner than the market determining the resale value. If you're going into
debt to make cosmetic changes to your house, try to determine whether the changes
add enough value to cover their costs.

Paying for a child's college education is another popular reason for taking out
home-equity loans. If, however, the borrowers are nearing retirement, they do need
to determine how the loan may affect their ability to accomplish their goals. It may be
wise for near-retirement borrowers to seek out other options with their children.

Should You Tap the Equity in Your Home?

Food, clothing and shelter are life's basic necessities,
but only shelter can be leveraged for cash. Despite the
risk involved, it is easy to be tempted into using home
equity to splurge on expensive luxuries. To avoid the
pitfalls of reloading, conduct a careful review of your
financial situation before you borrow against your home.
Make sure that you understand the terms of the loan and
have the means to make the payments without
compromising other bills and comfortably repay the debt
on or before its due date.


Behind The Scenes Of Your Mortgage


A mortgage can be seen as a stream of future cash
flows. These cash flows are bought, sold, stripped,
tranched and securitized in the secondary mortgage
market. The secondary mortgage market is extremely
large and very liquid.

From the point of origination to the point at which a
borrower's monthly payment ends up with an investor as
part of an mortgage-backed security (MBS), asset-backed
security (ABS), collateralized mortgage obligation (CMO)
or collateralized debt obligation (CDO) payment, there are
several different institutions that all carve out some
percentage of the initial fees and/or monthly cash flows.

Most mortgages are sold into the secondary mortgage
market. In this article, we'll show you how the secondary
mortgage market works and introduce you to its major
participants.

Secondary Mortgage Market Participants
There are four main participants in this market: the
mortgage originator, the aggregator, the securities dealer
and the investor.

1. The Mortgage Originator
The mortgage originator is the first company involved in
the secondary mortgage market. Mortgage originators
consist of banks, mortgage bankers and mortgage
brokers. One distinction to note is that banks and
mortgage bankers use their own funds to close
mortgages and mortgage brokers do not. Mortgage
brokers act as independent agents for banks or mortgage
bankers. While banks use their traditional sources of
funding to close loans, mortgage bankers typically use
what is known as a warehouse line of credit to fund
loans. Most banks, and nearly all mortgage bankers,
quickly sell newly originated mortgages into the
secondary market.

However, depending on the size and sophistication of the
originator, it might aggregate mortgages for a certain
period of time before selling the whole package - it might
also sell individual loans as they are originated. There is
risk involved for an originator when it holds onto a
mortgage after an interest rate has been quoted and
locked in by a borrower.

If the mortgage is not simultaneously sold into the
secondary market at the time the borrower locks the
interest rate, interest rates could change, which changes
the value of the mortgage in the secondary market and,
ultimately, the profit the originator makes on the
mortgage. Originators that aggregate mortgages before
selling them should hedge their mortgage pipelines
against interest rate shifts. There is a special type of
transaction called a best efforts trade, designed for the
sale of a single mortgage, which eliminates the need for
the originator to hedge a mortgage. Smaller originators
tend to use best efforts trades. (To learn more, see A
Beginner's Guide To Hedging.)

In general, mortgage originators make money through the
fees that are charged to originate a mortgage and the
difference between the interest rate given to a borrower
and the premium a secondary market will pay for that
interest rate.

2. The Aggregator
Aggregators are the next company in the line of
secondary mortgage market participants. Aggregators
are large mortgage originators with ties to Wall Street
firms and government-sponsored enterprises (GSEs),
like Fannie Mae and Freddie Mac. Aggregators purchase
newly originated mortgages from smaller originators, and
along with their own originations, form pools of
mortgages that they either securitize into private label
mortgage-backed securities (by working with Wall Street
firms) or form agency MBSs (by working through GSEs).

Similar to originators, aggregators must hedge the
mortgages in their pipelines from the time they commit to
purchase a mortgage, through the securitization process,
and until the MBS is sold to a securities dealer. Hedging
a mortgage pipeline is a complex task due to fallout and
spread risk. Aggregators make profits by the difference in
the price that they pay for mortgages and the price for
which they can sell the MBSs backed by those
mortgages, contingent upon their hedge effectiveness.

3. Securities Dealers
After an MBS has been formed (and sometimes before it
is formed, depending upon the type of the MBS), it is sold
to a securities dealer. Most Wall Street brokerage firms
have MBS trading desks. Dealers do all kinds of creative
things with MBS and mortgage whole loans. The end goal
is to sell securities to investors. Dealers frequently use
MBSs to structure CMO, ABS and CDO deals. These
deals can be structured to have different and somewhat
definite prepayment characteristics and enhanced credit
ratings compared to the underlying MBS or whole loans.
Dealers make a spread in the price at which they buy and
sell MBS, and look to make arbitrage profits in the way
they structure CMO, ABS and CDO deals.

4. Investors
Investors are the end users of mortgages. Foreign
governments, pension funds, insurance companies,
banks, GSEs and hedge funds are all big investors in
mortgages. MBS, CMOs, ABS and CDOs offer investors a
wide range of potential yields based on varying credit
quality and interest rate risks.



Foreign governments, pension funds, insurance
companies and banks typically invest in high-credit rated
mortgage products. Certain tranches of the various
structured mortgage deals are sought after by these
investors for their prepayment and interest rate risk
profiles. Hedge funds are typically big investors in low-
credit rated mortgage products and structured mortgage
products that have greater interest rate risk.

Of all the mortgage investors, the GSEs have the largest
portfolios. The type of mortgage product they can invest
in is largely regulated by the Office of Federal Housing
Enterprise Oversight.

Conclusion
In a matter of weeks, maybe a month, from the time a
mortgage is originated it can become part of a CMO, ABS
or CDO deal. Few borrowers realize the extent to which
their mortgage is sliced, diced and traded. The end user
of a mortgage might be a hedge fund that makes
directional interest rate bets or uses leveraged positions
to exploit small relational pricing irregularities, or it might
be the central bank of a foreign country that likes the
credit rating of an agency MBS. On the other hand, it
could be an insurance company based in Brussels, that
likes the duration and convexity profile of a certain
tranche in an ABS, CMO or CDO deal. The secondary
mortgage market is huge, liquid and complex with
several institutions that all take a slice of the mortgage
pie.
,Understanding Home Equity Lines of Credit

An equityline, or HELOC as it is commonly known, is
a line of credit secured by a lien on your home. As
with commercial lines of credit, you are allowed to
draw on your line at any time just by writing a check.
They are an excellent source of instant cash for
homeowners and can have significant benefits to
homeowners if used to finance worthwhile purchases.

We ought to get one thing straight, however. The
name comes from the fact that lenders base their
lending decision in large part on the amount of
equity you have in your home. In fact, these are
EQUITY-DESTROYING loans. You have LESS equity
after you use one. You will recall that part one of this
series was devoted to how to BUILD equity, not how
to DESTROY it.
One bank ad had bankers calling themselves the
“Equity Police.” They would show up at a home and,
finding “unused” equity, they would help people get a
loan so they could use it up. Frankly, I think that was
an inappropriate advertising program. I think banks
ought to help people INCREASE their equity, not
DESTROY it!

We have been through a period of unprecedented
growth in real estate values. Economists make the
case that people taking some (or all) of the increased
equity in their homes and spending it, sometimes
foolishly, were what financed the current economic
expansion. No economist measures good spending
versus stupid spending; it’s just consumer spending.
But I think that a lot of it was stupid.

PHILOSOPHY: My industry has made it very easy for
people to convert part of their wealth that was tied up
in home equity into “stuff” that the homeowners often
say was stupid a few years later.
The interest rate on HELOCs is adjustable, typically
tied to the prime rate and occasionally to T-Bills or
CD rates. With the prime rate at 8.25 percent today,
equityline loans are in the 8 percent to 10 percent
range depending on the borrower’s creditworthiness
and other factors. The payment you make each
month is based only on the outstanding balance and
is typically interest-only for the first ten years, at
which time the loan balance is frozen and converts
to an amortizing loan, still with a variable rate.

The major benefit is that you can draw on the
equityline any number of times. For example, you
can start out by paying off high interest rate credit
cards, lowering the interest rate perhaps from 18
percent to 9 percent. When that balance is paid off,
you may wish to finance a car with your equityline
instead of taking out a car loan. Finally, while they
are not a good substitute for true education loans,
they can be used to meet short-term needs, as when
the tuition bill comes around when you are a little
short on cash.
The interest on an equityline is, within limits, tax
deductible, a benefit that lowers the effective interest
rate compared with consumer loans and credit cards.

An innovation from the late 1990s is the “piggyback”
loan, where an equityline is used to finance the
purchase of a home. The homebuyer takes out a first
mortgage for 80 percent plus another loan, an
equityline, for the next 10 percent, 15 percent, or
even all 20 percent of the purchase price. That way
the homebuyer avoids Private Mortgage Insurance, or
PMI. If this interests you, find a competent loan
officer who can make the calculations for your
situation. In 2007, PMI payments are tax deductible.

Banks love equityline loans because the loans they
used to make on an unsecured basis are now secured
by equity in homes, thereby reducing their risk. I
understand that the default rate on HELOCs is so low
as to be immeasurable. The combination of a good
yield and low risk is something bankers dream about.
Equityline loans are very competitively priced and
frequently the lender will pay the appraisal and title
costs so they are offered with no or only nominal
upfront costs to the borrower. Be sure to check the
local banks and credit unions in your area to see if
someone is having a “special.” Some lenders charge
annual fees, but they are modest, perhaps $25 per
year.

NOTE: If you get a “no closing cost” loan, you can
almost always count on an early-termination fee if
you terminate the loan before, typically, three years.
WARNING: If your line provides for only interest
payments, you have to be diligent about paying the
balance down on a regular basis so as to regain your
equity. Before financing a purchase, be sure to
budget your monthly payment to retire your loan
balance. If you’ve used it to pay off credit cards, pay
the balance off in two or three years. If you use it to
buy a car, be sure the loan is paid off by the time you
wish to replace the vehicle, say in four years.
Remember, too, that walking around with that
equityline checkbook can be a temptation to buy
something just because you can. People who can’t
say “NO!” to their impulses should not get an
equityline. It will just get them in trouble. Be careful
not to use the equityline for frivolous purposes.
Summary
Equityline loans are attractive because they can be
used over and over as the need arises.
You pay interest only on the amount you use.
They are usually available for free or with only
nominal upfront costs.
They are not a good loan for those who have trouble
controlling their spending.
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