Borrowing Against Equity - What We Said In 2005

This is a warning about the lure and dangers of borrowing against home equity.  We wrote this in May of 2005.  In re-reading this today, I could not help but wonder at how prophetic we were.  I am including this as kind of a statement about the fact that we have been around in the real estate business long enough to have seen most things happen and have given solid advice to our clients and friends.  This was written at the height of the real estate bubble.  The advice still holds today.  We took our own advice and are still in our home.  A number of our readers took that advice and are riding it out.  Sadly, way too many ignored it and are in great difficulty or have lost their homes.  Also, sadly too many real estate agents, who should have known better ignored it too and have lost their homes as well.     

                A recent article in the Wall Street Journal noted that in the last several years a huge amount of wealth has been created in the continuing long running steep rise in real estate prices.  We have seen rises in price of somewhere in the neighborhood of 20% per year for a number of years now.  We have seen houses that were sold for $250,000 three years ago now going for $500,000!  If that house were sold today, there would be a gain of about $250,000!  Under most circumstances, there would be no tax due on this gain either! Most people do not make that much money in three years of working at their jobs.  This is a spectacular return on investment!

                Selling the home is not the only way to reap the benefits of this wealth creation.  The huge increase in value means that much of this wealth can be immediately used by taking out another loan on the property or refinancing the existing loan to a greater amount and pocketing the extra cash.  There has been a huge number of people doing just that.

                When wealth becomes available to us, it is only natural to come up with ways of using it.  As Realtors who have experienced both good and bad markets however, we feel the need to urge some caution in this.  Here is why.

                First of all, let’s start by re-visiting the history of property values.  It has been true that over time, property values tend to rise.  This is the long haul we are talking about.  There are shorter periods of time where values move up and move down.  Sometimes gradually, sometimes more steeply.  Over time though the tendency has been up.  We have seen lately a tendency of many people to believe that the recent several years of steep increases will continue indefinitely.  They are often encouraged by Realtors who have been in the business only long enough to have experienced the rising market.  (Actually, that is most Realtors out there today).  This exuberance and faith in constant increase leads some people to believe that if they borrow the maximum amount they can get on their home today, the continuing rising value will still give them more profit when they do decide to sell in the future.

                They could be right.  But we have been around long enough to see what happens to people who do that and the market takes a dip afterward.  It is not pretty at all.  It is actually heartbreaking in many cases.

                What happened to many people in the early 1990’s is a perfect example.  For a number of years, prices went down instead of up.  People who borrowed the maximum amount on their homes before the market dipped and then needed to sell during the dip, often had to actually come up with money out of pocket in order to sell there house!  Here is an example:  A couple borrowed the maximum amount against their home when it was worth $250,000.  At that time lenders were eager to lend money so they were able to borrow to a level of 90% of that value.  (Right now, people can actually get 100% and even more)! That was $225,000.  So they owed $225,000 on a house worth $250,000.  Then the market dropped.  Two years later the house was worth only $215,000.  The husband lost his job and could not find another one in this area.  After trying everything, he finally got a job offer in another state.  They had to sell.  The best price they could get at that moment was $215,000.  That $215,000 was not enough to pay off the $225,000 loan balance.  They had to come up with the $10,000 difference out of pocket to pay off that note and complete the sale.  There are also transaction costs in selling property.  They had to come up with that as well.  They were at rock bottom and still had to scrape up all of this money.  It was heartbreaking and we saw it happen many times.  Many people just walked away from their homes and let them go to foreclosure rather than come up with money they did not have.  They did avoid paying that money but totally ruined their credit.  It was a very, very sad time.

                Now you might say that if the people could ride out the dip until the market went back up, they could avoid that situation.  You would be right.  But that works only if you have the option to wait it out available to you.  Things happen to people that they do not expect.  They have happened to us.  Things change and you discover you must move from the home you thought you would stay in for many years.

                So now we get to our advice.  If you are gong to borrow money against your house, please, please do not borrow to the max.  Leave a decent percentage of equity available in case the market does drop and you suddenly need to sell.  How much cushion do you need?  That is difficult to say.  Part of it depends on how much you like to take risks.  We suggest you determine what your home would bring right now, (we can help you with that) and consider what it might be worth if prices went down 20% instead of up.  Then consider the transaction costs of selling the house.  Those two numbers might be a good place to start.   If you are really risk averse, you would increase the cushion accordingly.

                We are asked all the time if we think prices will continue rising like they have been.  We honestly believe that once  mortgage interest rates do take a serious bump up, the rise will slow or flatten out.  We certainly do hope it will not go the other way.  As I said, we have been there, experienced that and it is no fun at all.