A Real Look at Home Equity Abuse in the Nation

by David@MoneyNing.com · 16 comments

California is a beautiful place to live in since there’s no shortage of pacific ocean views down here. The gorgeous surroundings and year round perfect weather have attracted many who want to buy a house here. During the last decade, this went to the extreme as home prices went through the roof..

I frequent a local housing blog daily, and a property it featured a few days ago really raised my eyebrow. The owners of the house managed to withdraw $886,800 through home equity loans during the 14+ years that it’s been occupied. While these examples are abundant in places close to where I live, this one takes it a step further because the owners only put down $29,300 in 1994 for the house that cost $263,200 at the time. Apparently, the home values appreciating fives times at well over $1 million dollars (again, with a $29,300 down payment) isn’t enough to keep them afloat.

Oh my god.

If I told you that you can make 30x the investment in 14 years, you’d think I am just a salesman who is trying to sell you a financial product. In fact, if a buyer accepts the asking price, it would make the investment close to 56x but I heavily discounted the multiple because it’s hard to say how much the house will eventually sell for.

With decades of good fortune in the home purchase, what was left? Memories of a lavish lifestyle and nothing more.

Why? While the owner is asking for close to $1.6 million, it’s improbable that someone will buy it at those ridiculous prices. There are much newer homes for sale in nearby areas for as much as 25% less, so even 25% off the asking price might be too high. With the total debt of the property at $1.15 million (HELOC + mortgage), the owner will be lucky to come out even.

  • Hopefully, the family will learn a lesson.
  • Hopefully, this gives you a glimpse of why we are in such a mess.
  • Hopefully, nobody tries this again (or at least for a very long time)

Reading these types of stories makes you wonder. Maybe:

  • It’s not all wall street’s fault for creating this mess.
  • It’s not the government’s fault for trying to help.
  • We should share some of the blame too.

Responsible spending lessons should be drilled into every America’s mind, because our survival as a nation will depend on it.

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{ read the comments below or add one }

  • Tim Southee says:

    As the title of this article would suggest, I am going to take you on a journey through the ups and downs on fixed rate mortgages. When buying a house, especially the first one, I think that it is literally the most terrifying experience that I have been through, and I have combat experience as a military veteran. For those of you who find yourselves still anticipating the purchase of your first home, let me give you a brief rundown of what it is and what it isnt. What it isnt will be the easies to tell you about. It isnt like going to the store and buying what you want by swiping your card. It isnt even like buying a new car, although the new car buying experience is a little bit closer. It is like looking at dozens of houses that you hate in order to find one that you like, only to learn that it is 10,000 more than you wanted to spend. So you make an offer and wait to see if the seller takes the offer or sends back a counter-offer. Once the game of offercounter-offer is through you set up a closing date. At the closing you sit down and sign enough papers to make Leo Tolstoy quake in his boots. Once that hour devouring procedure is done, the house is yours and you are in debt for 30 years. Sounds appealing doesnt it? Well, actually, it really is. But, before you get to the point where you can sign all those papers, you have to decide on what kind of loan will be best for you. There are a couple of different options and, in this first installment, I will discuss the fixed rate mortgage.

  • JP says:

    MoneyNing: I’m curious, what do you feel is a good % to have in equity in your home, either in terms of its value, or in terms of your net worth?

    For instance, I have a 6% jumbo loan on a house I have 30% equity in it. I’m considering doing a conforming loan + HELOC combo to take advantage of the low rates, but the variable rate of the HELOC is unsettling in that I have a strong suspicion that inflation will really kick off in the next few years to help erase all that public debt. Assuming that occurs, that will leave me in a worse situation, unless I flood the HELOC with cash to close it out – effectively puting me in for another 30% additional equity. Take in the inflation, I could quickly find myself with 75% ownership, which will drastically weight my house high on my investment diversification. Hence my question.

    – JP

    • MoneyNing says:

      JP: I think just throwing a % out there is too general and let me explain why. If someone has a net worth of $500k, the percentage should be much different than someone who has $5 million.

      Also, I think that the % equity question is more for people who are looking to buy into a home, and not as much for someone like you who already has one since changing your house is a major expense and not just a matter of “re-balancing” like stocks for example.

      It sounds like you have a large portion of liquid funds to pay off the HELOC if rates does jump, so if the refi and HELOC setup etc aren’t too expensive to do, I’d totally do it and would pay down the HELOC as soon as rates jump. In the mean time, you can pocket the difference of lower rates. I’d also try to see if there’s a way to get rid of the private mortgage insurance since you are probably paying for it when you don’t need to with the liquid assets that you have.

      Going back to your fundamental question though, there’s really no right answer as there’s no magic number to shoot for but let me share with you an observation that may help. Chinese people (I think it’s actually all Asians but I may be wrong) as a culture is much more conservative in terms of investments like these. In America, 30% equity is considered very high but many Chinese would be doing everything they can to pay down that mortgage “debt” even if they own 90% of the house. That’s why there are many Asians who will pay cash for a house because many Americans with that type of purchasing power would be using just as much cash as 20% equity and buying a house that’s 5x as expensive.

      Of course, there’s no right or wrong way as it’s all just a personal choice. Using the cash to invest definitely makes sense mathematically, but no one ever gets poor being debt free. Remember that our end goal is to be satisfied and happy with our life, and not gaining every last cent possible. When you take more risk, there is a higher level of extreme success but also a higher degree of failure.

  • marci says:

    Yep – I can understand the call on the house vs condo deal. Ever consider moving where the houses are not so expensive? 🙂 That’s my answer to it all.
    And I’m not worried about resale… at this point I’m pretty much dug in til I die here – and happy to be here 🙂

  • MoneyNing says:

    marci: I think it’s much easier (psychologically at least) to buy a $150,000 house when most houses are about $150,000 in the area but when a single family home is $600,000, you convince yourself that it’s a better choice than a 2 bedroom condo for $300,000 even though you still get the roof over your head. (an even better choice financially is renting a condo for much less but most people believe that “buying” is always better)

  • marci says:

    Thanks, David. Obviously I don’t think too much like others do 🙂
    Why would anyone buy a $600,000 house when your exampled $300,000 one would put the same roof over their heads? … ish….. I have always tried to buy for the least possible – but get the most bang for my buck… I just hate to spend more money than I have to.
    Of course, I had several people tell me I should just burn down the house I bought this last time, for $2000 more than the cost of the lot, but with a LOT of elbow grease and paint, it has turned into a wonderfully comfortable home for me and the grandkids 🙂

    Thanks for pointing out the cost of houses there – truthfully, it is mind boggling…. No one here makes that kind of money to start with, and luckily the houses do not cost that much either – as long as you don’t buy oceanviews… which is rather spendy, (well over a million for a windy sandy salt encrusted damp mess) even here. I passed up a 4 bedroom 2 bath, carport on 2 acres last summer for $150,000 because my house wasn’t finished then to sell and/or trade. But right now there’s a 3 bedroom, 2 bath, 2 car garage on 1/2 acre for $130,000…. or I could just add a garage on to this place and call it good 🙂 There’s a nice fixer-upper 2 bedroom for $60,000 in town…. any takers?

  • MoneyNing says:

    marci: Thanks for the disagreement 🙂 I always like to hear what others have to say. In your circumstances, it worked out great for you because you were using the bank’s money to the advantage. If you have cash on hand and it’s earning 10-12% but your mortgage (or any loan for that matter) is earning 6-7%, then math tells me that you should borrow as much as you can so even 10% might be too much.

    You have to remember that most people aren’t like you in being responsible with their money. When they pay down 10%, that’s pretty much all they have saved up. With no savings and just an income with a mortgage payment, what happens if that person loses his/her job? Since most people’s income are based mainly on their salary, the income to debt ratio when you are trying to leverage 10x your down payment is VERY risky.

    Let’s take an example. Let’s say someone makes $150,000 a year and he is debt free. That means he has $45,000 a year (with a 30% debt to income) for his mortgage and insurance. Let’s just take $43,800 and leave the rest for other house related expense. With that kind of purchasing power (according to income to debt ratios), he can pay $3,650 per month mortgage, he can get a $720,000 mortgage at roughly 4.5%. Then with a $80,000 down payment, he can buy a $800,000 or so house. (you may think the numbers are big but here in California, there are tons of cases which are much worst)

    This scenario might be fine for some people, but what happens in our current situation? Housing went down at least 20%, so refinancing or home equity loans aren’t possible (this is where the down payment becomes useful). If the person above loses his/her job, the $3,650 every month + expenses, which for someone like him might be $7,000 or even $8,000 (most of the time, even more) a month doesn’t go away. At that burn rate, that person better find a good paying job fast, because he is going to use up his savings/investments VERY quickly.

    The likely scenario is that the person would take 6-8 months trying to find a job, and instead of getting $150,000, his salary becomes $120,000 if he’s lucky. For this example, the mortgage all of a sudden is 36.5% of his salary. If he has at least $64,000 in savings, then this person would be fine. If he doesn’t (which most people who bought a house don’t), then the foreclosure process start.

    While responsible people can take advantage with a smaller down payment, it doesn’t make sense for the banks or mortgage companies to offer it because:

    – Even responsible people will have problems when the total mortgage amount is high (see example)
    – Banks will never be able to tell how responsible or irresponsible you are. They can only tell how much you make currently and how much you have in your bank account.
    – With relaxed rules, most people will abuse it. For example, if I have $60,000 and want to buy a house, most people will try to buy a $600,000 house when the rules are 10% down because those look nicer even if the responsible thing might be to get $300,000 house and pay $30,000 with some savings left just in case.

  • marci says:

    David: I’m going to have to respectfully disagree with you on the 10% down deal. I think the problem is NOT in how much down (provided it’s 10% or more) but in the percentage of take home income the lenders allowed as a total housing cost. I think if more people would have keep the total payment needed (including taxes and insurance) at 25% of take home income or less (30% tops) then there wouldn’t have been so many failures. Encourageing people to have a total payment needed of 50% or more of their take home pay (not gross) was financially irresponsible, in my book.

    I once put down only $2000 cash on a $275,000 farm. It was the right deal at the right time, and the farm was paid off in 14 years. I think people who are careful with their money can do these things, but it’s not for the average person who does not have savings and investments to back up their purchase should something go wrong. (No, it was NOT thru a bank – it was an owner contract)

    Personally, I have never put down more than 10% on any house or property because for me, it would be a financial error on my part to do so (in most cases). One exception would be a home that will not finance (like the one I just bought for the price of the lot only) and so I paid cash for it. When my money was in the bank earning 10-12%, and a home mortgage interest rate was 6-7%, it did not make financial sense to withdraw my high interest earning money on a lower interest loan. If I let my money sit in the bank, the interest earned alone would make my house payment.

    One of my first rules of buying property was to not use my own money – ie, use the bank’s money, or a private contract, and let my money sit there and grow bigger. As long as the investment was bringing in a higher interest percentage than the mortgage interest percentage being paid out, it was more financially sound to leave my money sit and put as little down as possible. Just my opinion – but it has worked for over 30 years for me.

  • Funny about Money says:

    World-class greed and stupidity. We should have had Olympic competitions in these sports: those home”owners” would surely have brought home at least a silver medal. Maybe the gold.

    But…WHERE were the banking and lending regulators? What went wrong that unscrupulous lenders were allowed to lead the dumb and the feckless down this particular garden path? We got idiocy, all right. But just as we don’t got milk in our glass without some help from the cow, we don’t got stupid without some help from various enablers, either.

  • Emily says:

    Hopefully, those people read your post daily.

  • MoneyNing says:

    marci: 11% may be common but I certainly don’t believe it’s adequate. If everyone was forced to put down 20% (or maybe even 30%), then the housing prices would never get out of hand in the first place and probably more people would end up owning homes since they can actually afford them as long as they were responsible.

    Allowing everyone to buy with a small down payment is totally not the right incentive model for a more responsible society.

  • marci says:

    His down payment was 11%…. that’s over the 10% that is so common, and nowhere near the 5% for the low income loans. So at the time of purchase, I’d say his down was adequate. So why the “only” ? 🙂

    Hard to believe the outcome of the rest of the story tho after such a decent start on it.

  • Lance W. Newton says:

    From it’s inception, America has been built on debt.

    In character, this soon to be great depression is no exception as leveraged debt in mortgages reached more than 50% of gross income(s) in places like CA and the cost of revolving debt service per household peaked at over 14% of gross income in 2005. Based on many years of actual results, bankers know that mortgage debt is not sustainable at levels more than 28% debt to income on a 30 year fixed mortgage. What happened was allowed to happen in spite of history and because of greed on all sides.

    Thanks to a commercially nurtured consumer mentality aided and abetted by a profit hungry financial sector, the “savings rate” in 2005, (manifested in Mortgage Equity Withdrawal and revolving credit use) was officially reported at -2.5% but was really more like -13%.

    Thanks to “exotic” mortgages, people that should have qualified for and purchased a $500,000 home on a 30 year fixed rate, qualified to purchase a home priced at $1,000,000 using two interest only loans, with 3% down. Prices inflated because people could qualify using unsustainable loans. In your example, the borrowers were allowed to strip equity using a HELOC that probably had a variable rate as well.

    Keep in mind there has also been a not so subtle shift in the costs of health care and pension savings to wage earners from corporations during this time, in addition to lots of new, expensive “indispensable” services like cellular phones and cable TV. The media, supported by commercials was only to happy to propagate the “Life Styles of the Rich and Famous”. In 2006, I saw a womens magazine with a cover article that read something like “763 things I want now”.

    As desirable a place California may be to live, we reached a point where the ratio of housing price to median income was more than 20x in coastal areas and more than 10x in places like San Bernardino. Historically it was more like 3x. The bubble popped on the periphery and is slowly working toward the coasts. Who knows where prices will settle, but our coasts are treasured the world over, where people built productive businesses and saved like there was no tomorrow. They can still pay cash.

    The “solutions” to the crisis being offered are more leverage and bailouts to the billionaires whose greed promulgated the environment that sustained the bubble. The only time consumer spending was a higher percentage of GDP was in the late 1920’s, when it reached 83% in America.

    If the free market is not allowed to determine property values in residential real estate once again this mess will drag on for years and our grandchildren will be little more than tax serfs. (See “Going Down with the Joneses” at http://www.box.net/shared/cfje9z2vpv)

  • Greg says:

    Accountability needs to be shared by all that is a fact but I wonder why somebody would continue to do this.

    Even though money for me right now is not a concern I agonize over buying a TV, but of course I pay with cash. Scary how we allow ourselves to get into this mess.

  • My Life ROI says:

    I couldn’t agree more with “We should share some of the blame too.”

    I just can’t stop thinking what idiot lender kept extending the credit? Greed motivates, eh?

  • ObliviousInvestor says:

    Holy cow. That’s some serious home equity spending.

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