The Check's in the Mail

Shannon Brady

The day that Thomas Patterson received his umpteenth mailer announcing his eligibility for an "instant" loan, water was pouring from the upstairs bathroom into the kitchen below. Strapped for cash and having exhausted his line of credit, Patterson--not his real name--called the number listed on the faux check. Within a few hours, $40,000 had been deposited into his bank account for home repairs and debt consolidation. Six months later, however, Patterson is deeper in debt than ever, and this time he's at risk of losing his home.

According to financial experts, he's one of an increasing number of unsuspecting borrowers who have been seduced by a new kind of loan allowing homeowners to borrow up to 125 percent of the value of their house. And within the year, they predict that this new lending instrument will dramatically increase the number of foreclosures.

Last summer, a new job enabled the Patterson family to move from its small rambler into the home of their dreams--a four-bedroom, 3,100-square-foot house located in a quiet, middle-class suburb northwest of the Twin Cities. The house cost $170,000, but since Thomas Patterson would be pulling in $70,000 a year in his new sales job, he was confident that he could swing the $1,200 monthly payment while letting his wife stay home with their three small children. However, he now concedes, he should have seen that his budget was already stretched to the breaking point. "I also had $20,000 in credit-card debt," he admits, "and I'd maxed out my $15,000 express line of credit with the bank."

So when the bathroom floor threatened to spill into the kitchen, Patterson picked up one of the mailers that had been lying around the house. He contacted Pacific Prime Mortgage, a privately owned brokerage firm based in California, and applied for what's known as the "125-percent" loan. Consumers with "unblemished credit" are able to get up to 100 percent of the value of their homes plus an additional 25 percent to use at their discretion. In Patterson's case, he says, he planned to use the money for home repairs and other "necessities."

Prior to 1979, the federal government set limits on the amount of interest banks and savings and loans could legally charge and pay customers. While savings-and-loan institutions were allowed a bit more leeway, in order to qualify for federal insurance on deposits, both types of institutions had to toe the government line. But at the end of the Carter administration, the federal government deregulated the banking industry, in part in the name of free-market competition. One result was that in an attempt to get an edge on competitors, banks began making it increasingly easy to borrow money, offering a steady stream of new types of loans. For example, homeowners used to have to put up substantial down payments. But faced with competition for mortgage lending, banks have steadily lowered the amount a buyer must produce.

Within the past year or so, explains Dan Hardy of the Minnesota Mortgage Bankers Association (MMBA), some savvy financiers realized that a growing number of homeowners were carrying substantial credit-card debt and were looking for ways to consolidate their bills, preferably at lower interest rates. Although consumers in this group tend to have a lot of debt compared to their income, they also have sterling payment records. No matter how onerous, most always pay their bills on time.

The combination of these two elements--a large debt load coupled with a diligent payer--is particularly alluring to lenders, especially as the likelihood that they'll pay off early is slim to none. "Financial institutions make their money off the servicing of the loan," or interest, says Hardy. "They lose money when people prepay." From a consumer's point of view, a home-equity loan is the best kind of debt to carry. Unlike credit-card interest, the interest paid on such loans is usually tax-deductible, making them cheaper in the long run.

Plus, says Patterson, there's the "lure of easy money": "You can get thousands of dollars within a few hours, and you can do it all from your home." This is due, in part, to the fact that the bulk of these kinds of loans aren't made by banks. Should a firm like Pacific make bad loans and consequently go belly-up, it answers only to its stockholders. But should a bank shut down as a result of these risky loans, it has to answer to the federal government because tax dollars are used to reimburse account-holders for their losses. And as the S&L crisis of the '80s taught us, the taxpaying public ultimately bears the bailout burden.

At the time of his loan, Patterson had paid off $24,000 on his home, so Pacific offered him $60,000. He opted to borrow $40,000 at 13.5 percent interest. "Part of my rationale was that I could get some things done around the house that I couldn't otherwise afford." Plus, he reasoned, since the term of the loan was more than 10 years, the monthly payments would be low.  

That's true, say debt counselors, but Patterson had nonetheless fallen into the same thinking that drives millions of consumers into bankruptcy each year: "If it's being offered, then I must be able to afford it."

Excluding mortgages, the average American household owes $11,600, says Wayne Wensley, president of Consumer Credit Counseling Services of MN, Inc. Between $6,000 and $7,000 of this is usually credit-card debt, he explains, adding that bankruptcy filings have risen 22 percent in Minnesota over the past year, hitting an all-time high for consumers. "But we're still better financial managers than most of the country," Wensley adds. Nationally, bankruptcy has risen 28 percent.

Wensley and others contend that debtors fall into one of two categories: situational and behavioral. The situational types have fallen into debt due to job loss, divorce, or a major medical expense, while the others are those who "will not or cannot" manage their money, says Wensley. Patterson, adds CCCS financial counselor Mike Isabel, is a behavioral debtor. "The problem related to overspending," he explains, "is that the consumer has the false sense that everything is wonderful. That they'll be employed long-term, won't suffer from any unforeseen problems, and the economy will remain constant." If you take out a 125-percent loan and fail to adjust your lifestyle, says Wensley, you'll find yourself in a deeper financial hole than before. "People take out consolidation loans or other types of loans, but will continue with the same behavior that got them into trouble in the first place."

Changing spending habits, however, is just one of the things consumers need to consider when taking out this kind of loan. If you take one out to pay off your credit cards, explains Wensley, and lose your job and can't make the payments, the company can foreclose and you'll lose the money you've invested in your home. "What people don't seem to understand is that they're using their house as collateral," he says.

Another bit of fine print that's lost on borrowers, adds Hardy, is that the 25-percent part of the loan isn't tax-deductible. "That part is what's known as an unsecured loan, and by law is not tax-deductible," he explains. That's news to Patterson, who maintains that Pacific told him neither that he could lose his house nor that some of the loan wasn't deductible. "I spoke to a company representative for over an hour," he says incredulously, "and he didn't say a thing about this."

And it could get worse, adds Hardy. According to industry reports, he maintains, the refinancing industry is scrambling to stay afloat. "In the last few weeks, one company's stock dropped from $32 to $1." Hardy attributes this development to steadily decreasing interest rates. "Consumers are now able to prepay, so the companies that service these loans are losing money." To get around that, he says, companies like Pacific are now considering prepayment penalties.

As for the traditional mortgage industry, says Hardy, the jury's still out on whether this lending instrument is worth the risk. He knows of no Minnesota companies offering them. "Banks are sitting back and trying to get the lay of the land," he says. "If consumers embrace 125s, they may decide to get a piece of the action."

Despite the risks involved, Hardy and other financial experts maintain that for a select few, 125s work quite well. "Depending on how disciplined you are, these can be a good product," says Hardy. "If your credit-card interest rate is between 18 and 20 percent, and the refinancing rate is 10 percent, then it's a good deal." Otherwise, he warns, perhaps it's best to steer clear. "Just because someone offers you $40,000 on your mortgage with no questions asked doesn't mean you should take it."

Although Patterson isn't in immediate danger of losing his home, one swipe of misfortune will topple his financial house of cards. Since he didn't use the money for value-adding improvements, he may have exchanged more debt for little or no extra equity. To make matters worse, when he got the Pacific loan, the bank increased his credit line, and Patterson ran through that $15,000 as well. His monthly payments, without credit-card payments, now include a $1,200 mortgage payment, $466 for Pacific, $350 for a minivan, and $320 to the bank.

Patterson has recently sought help from a financial counseling service, and says he should be debt-free by 2015, right about when his three kids will be college age. That is, providing he changes his ways.

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