Home Equity or Debt Trap?

Are you using the equity from your home to purchase everyday things? This is a dangerous trend growing more popular every month as millions of Americans tap into the value of their home to fund a lifestyle.

How many times have you heard the saying “Your home is the best investment you’ll ever make”? How many times have you also heard that your home will be the most valuable asset you will ever own?

Both of these are as true, if not truer, today than at any time in the past. Unfortunately, spend happy Americans are looking at their home as just another type of ATM, and they are visiting it way to often. These homeowners are using money borrowed against their house to finance expensive vacations, new vehicles, even daily visits to the corner coffee shop.

Our parents wouldn’t think of buying furniture with money borrowed against their home. So why is this form of borrowing becoming so popular? Three events have converged to create this dangerous trend.

1. Cheap interest. The past two or three years have seen interest rates unheard of since the 1950’s. These low rates encourage people to think they have basically free money to spend however they want to.

2. Real estate value increases. The Office of Federal Housing Enterprise Oversight (OFHEO) reports that their data shows market value of the average home increased nearly 13% in 2004. That is more than any time in the last 25 years. Some areas saw the value of homes double in less than 5 years.
This increase in value is perceived by some people as being a bonus – they didn’t have to work for the money, so it doesn’t cost them anything. They are right about it not costing them anything, except they forgot that when they borrow money it has to be paid back. That is when the true cost of the debt appears!

The U.S. Department of Commerce reports in 2003 nearly half of the $8 trillion in outstanding mortgage debt was in new mortgage originations. This doesn’t mean home equity loans are necessarily bad ideas. Using equity in your home to remodel and make additions can result in solid returns. Even debt consolidation can be a good choice, provided you have solved the problem that caused the debt in the first place.

3. Ease of borrowing. Twenty years ago, lenders wouldn’t think of giving you a loan, even against your home, if it would cause your equity to become less than 20%. Some insisted in a percentage closer to 50% equity. Those days are long over.

Today you can go online and find a lender willing to give you a loan equal to 125% the value of your house! If you have a credit of repayment, hold a job, and are still breathing you can probably find a lender willing to let you borrow against your home equity.

The risk created by the convergence of these three factors is the loss of your safety net. As people buy homes at the top end of their range and base mortgages on two incomes something has to give.

This “something” has been their savings. Putting aside part of each paycheck has become the low priority in the pile of demands barraging a family’s income.

Data released by the Employee Benefit Research Institute reports nearly 45% of all workers hold assets of less than $25,000 (excluding their home). Barely 67% of today’s workers are currently saving money in a 401(k) or some investment program, according to a Thrivent Financial Survey.
Does any of this sound familiar to you? The looming debt of mortgage, college, and credit card can seem overwhelming. How can you tip your financial life back into favoring a secure future for yourself and family?
Here are five steps to escape the home equity debt trap.

1. Keep track of expenses. Keep a spending record of everything you spend for one month. The next month, do it again, and the next month too, until you see areas of spending you can cut back and use that money to fund your lifestyle goals, i.e. vacation, college, or a new lawn mower.

2. Create realistic debt reduction goals. List all of your debts with interest rates, outstanding balances and minimum payments. Create a plan to pay down the debt, preferably pay the same set amount each month no matter what the minimums are. Anything extra you pay should go to the smallest debt first. When a credit card is paid off, get rid of it. Perhaps a small reward like a special meal when a goal is reached will help keep you motivated.

3. Preserve your home equity. Having home equity untapped in your house can provide a level of reassurance. Making wise uses of this equity will help you to not exhaust it. When you do tap into your home equity, make sure it is not used to pay for daily living.

4. Pay as little debt interest as possible. Consolidation of debts into low, or no interest loans i.e. credit cards, is acceptable as long as you refrain from incurring new debt and you are paying down the debts you do have each month.

5. Start saving regularly. A fund of money for emergencies will help avoid debt when life throws you a problem. If you consider saving a “non-optional” bill each month, you will develop the find habit of saving. The result is a growing asset base.

The end result of taking these five steps? A minimal-debt life spent living in an affordable home of your own.