Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
The latest reports on Americans’ growing wealth focuses on the stock market, which has added more than a trillion dollars of net worth to family balance sheets.
The “wealth effect” means that people are willing to spend more, and hold less money in traditional savings categories, because of the belief that the stock prices will continue to rise. Yet a large percentage of those market gains is locked up in retirement accounts--money that may not be spent for years, or even decades.
So where are consumers getting the cash they’re spending?
Surprisingly, a large portion of America’s growing wealth comes from a source closer to home--the family home. The median value of a single-family home has gained about 50 percent over the past 10 years and now stands at $133,100, according to the National Association of Realtors. And consumers are unlocking that growing value through refinancing mortgages and taking on home equity loans.
The Federal Reserve says that the average capital gain realized through a home sale totaled about $150 per year in recent years. And with new tax rules allowing consumers to keep more of the profits on the sale of a home--up to $500,000 for a couple filing a joint return--home sale money stays in consumers’ hands, for a while. Plus, home equity loan totals have topped the $400 billion mark in each of the past two years.
All that cash is keeping the economic boom alive, as consumers buy cars and computers, go on vacations, and remodel the kitchen. Certainly, some of the money has gone into the stock market.
Up to a point, unlocking the wealth in your home makes sense for sophisticated consumers. Who’s to judge whether the wealth is better used in purchasing a stock, buying a car, or left in bricks and mortar?
The dangerous aspect of this situation is that so many consumers are going far beyond the point of unlocking real estate wealth. Instead, they’re leveraging the family home in several dangerous ways.
Over the past few years consumers have been bombarded with ads promising home equity loans that could be used to consolidate debt or take a long-desired vacation. Television commercials feature popular athletes promising to make the entire process easy, even for those with bad credit. Consumers can even borrow up to 125 percent of the value of their homes!
Since I last wrote about the dangers of these highly leveraged loans, two of the largest lenders have gone out of business. They were packaging and selling the loans to investors, who decided to shun this “sub-prime” market in the wake of credit concerns following the collapse of Long Term Capital Management Corp. But, according to SMR Research, which follows the financial services industry, there’s still plenty of demand for the loans from consumers looking to get out from under credit card debt.
I received an e-mail this week, promising “Cash for Debt Consolidation” available even to homeowners with bad credit, previous bankruptcies or foreclosures! The low initial rates are sure to jump in a few months, and homeowners will once again be burdened with high-interest rate debt.
Because of the way payments are amortized on home equity loans, the monthly cost is lower. And some portion of the interest will be deductible (but not interest on any amount over 100 percent of the home’s value).
The deductibility feature makes these loans enticing. But the danger is that the borrowers may pay off their credit cards now, only to load them up again on a spending splurge.
The industry term for it is “reloading.”
But the next time the borrower can’t pay his or her bills, the family home will be foreclosed.
It’s not just consumer debt that’s leading people to pledge their homes as collateral. Equally troubling is the problem of stock market greed. Some of the nation’s most prestigious brokerage firms are offering no-cash-down mortgages. Instead, you can pledge the securities in your investment account.
Logically, this may have great appeal. Instead of selling stocks and paying capital gains to buy your home, you just put them in a special margin account. That way you’ll get to keep the gains from your stocks, and the gains from your real estate.
It all works very well when the stock market is rising. These accounts typically require stocks in the account to equal 40 percent of the amount of the loan. But if the stocks’ value declines to 30 percent, the borrower can receive a margin call.
It hasn’t been an issue yet, because of the stock market’s upward surge. But many of these loans are interest-only deals, at least for the first few years. Any prolonged market decline could force these folks to choose between selling their stocks or their home.
The Depression Generation learned a lesson the hard way. At one point in the mid-1930s, banks categorized 20 percent of all mortgages as “real estate owned,” that is, foreclosed. Those days are long forgotten, except for one eerie statistic.
In 1998, in the midst of our current economic boom, about 1 percent of all outstanding mortgages were in the foreclosure process. That’s nearly double the rate of the worst recent recession period in the early 1980s, when 0.59 percent of all homes were in foreclosure.
Admittedly, it would take a lot of things going wrong at the same time to re-create the disastrous scenario of the 1930s. But higher interest rates could affect the value of stocks, and the affordability of homes, and the availability of jobs to make payments on both.
Before you get too far down the road of leveraging your home, think twice about keeping a roof over your head.
And that’s the Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Devon Energy Corp. Send questions via e-mail at savage@
suntimes.com. Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.