Blown Mortgage

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If you own a home with a substantial amount of equity the recent news reports of potential home price drops of 15% to 50% in the next year must be alarming. Particularly if you were planning on using your home equity to fund retirement, college or other large obligations in your future. Watching equity that you were counting on disappear in to thin air makes everyone queasy. But don’t feel powerless - there are a couple of ways to protect your home equity from a falling home market.

The No-Cost Home Equity Line of Credit is one excellent vehicle that can be used to protect your equity. There are others, which we’ll cover in future posts; but today we are going to focus on using the Home Equity vehicle as a way to protect equity in your real estate. Of course, there isn’t anything that you can do to control the proclivities of your local market and the capricious way in which the housing recession (and we’re headed that way) will wipe out thousands of dollars of equity appreciation racked up over the last 5 years; market forces and your neighbor’s lack of judicious financing will handle that with out your say. But there is a way to provide you liquidity instead of inert equity(at a cost) and to separate your equity from a, for now, depreciating asset.

The concept of equity separation is not new. It is one that has been touted by such authors as Doug Andrew in Missed Fortune, and the spawned legions of mortgage professionals playing the quasi-advisory role associated with the ideas involved with equity repositioning. It is a charged debate. Opponents argue that equity repositioning is merely a con to allow mortgage providers to repeatedly refinance unwitting clients collecting thousands of dollars in fees. Proponents argue that equity isn’t worth anything until it is working for you, an argument that is playing out right now with dollars being taken off the top of every home in America today.

While I will not attempt to dive in to the murky waters of equity repositioning as a way of financial planning in this post (I may get braver in the future) I do want to highlight just one element of the strategy as a way to protect your equity from current market conditions.

No-Cost Home Equity Lines of Credit (HELOC)

For a brief primer on HELOCs please visit my first post about using Convertible Home Equity Lines of Credit to lower your overall interest rate expense when financing loan amounts over $417,000 (also known as jumbo loans). The basic concept of using a no-cost HELOC to protect your equity is a simple one. It’s logic is as follows: Today your home is worth more than it will be tomorrow (and for the next 3-5 years) and it will decline each day until housing recovers, eliminating thousands of dollars in equity as the value decreases. Further, banking guidelines will continue to constrict, reducing the number of programs and benefits associated with loans over this time period (evidenced clearly in the last few months). With these truths in place (and they are not argued by most rational people) it makes sense to put in place financing that takes advantage of the highest value of your property and the most beneficial loan programs - both of which are available today (and decline here on out).

Because HELOCs are only available up to a certain percentage (called loan to value or LTV) of your home value each day that your home declines in value the amount of equity you can protect with a HELOC declines. By using a no-cost HELOC you effectively “lock in” your access to the equity in your home defined TODAY, regardless of what your home is worth TOMORROW. You freeze the value of your home equity by forcing the bank to put a real number on it and creating access to it via the HELOC; all at no cost to you.

The best part is that you don’t have to take money out of your HELOC to protect your equity. While banks may have a minimum withdrawal, “draw,” requirement at the beginning of the loan; you can quickly return it to them to return your balance of the HELOC to zero. By leaving your HELOC at zero you don’t incur any additional debt-service obligations to your monthly cash flow; but you do open up and protect the equity in your home.

Not All HELOCs are Made Equal

It is important that when considering the equity-protection strategy utilizing the HELOC vehicle that you research and review the HELOC options available to you. The biggest ones have to do with the interest rate tied to the money borrowed and the closing costs associated with setting one up. I recommend a no-cost HELOC for establishing an equity protection HELOC as they are readily available and don’t diminish your existing equity or cash position with fees.

A true no-cost HELOC will have no fees associated with it. No appraisal fee, title or escrow fees, origination, processing or other fees. This is the best way to establish a HELOC for equity protection.

Some HELOCs may require you to take an initial draw. This means that if you establish a $100,000 HELOC you may be required to take a certain amount out at the beginning. This is usually because the bank makes money on the money borrowed; and requires the withdrawal at the beginning. Additionally, loan agents are often paid on a commission of the initial draw, and not the size of the HELOC. A loan agent may encourage you to even take the whole amount at the beginning and return it a month later to simply earn themselves a larger commission! There are some HELOCs that don’t require an initial draw; these are the best in terms of limiting unwanted interest expense. Ask for a HELOC that doesn’t require an initial draw.

Some Charges in the Transaction

Depending on the type of HELOC that you choose you may be responsible for certain charges.

Title & Escrow - Some HELOCs are “low cost” instead of no cost, eliminating everything except for title & escrow fees. You may be responsible for these if you choose a “low cost” HELOC.

Appraisal - While some HELOCs don’t require an appraisal (relying on an Automated Valuation of your home, “AVM”) others will. Make sure to clarify at the beginning of your conversation whether you’ll be responsible for an appraisal or not.

Line termination fee - If you choose to close your HELOC at any time the bank my charge a line termination fee. This typically costs $500 and is rather standard on all HELOCs.

Loan Origination fee - Some HELOCs may have loan origination fees on them for the broker or loan agent. As I mentioned, I recommend a no-cost HELOC (often called a “courtesy second” or “courtesy HELOC” by loan agents) for equity protection purposes. Don’t be confused by the word “courtesy” the loan agent still gets paid for establishing your HELOC.

Next Steps

The next step in the process is determining what you want to do with that now-available home equity and how you’ll do that. That will be the subject of future posts. But right out of the gate let’s make clear that using home equity on similarly depreciating assets is a terrible idea; and one that has led us to the brink of this housing recession.

Last 3 posts by Morgan

• Gaming Home Values and Their Consequences - January 7th, 2009
• What We're Reading 1/4/09 - January 4th, 2009
• What We're Reading 1/3/09 - January 3rd, 2009