Just say not to home equity loans

"Cash out your home equity while rates are low," "Use your home equity as a checkbook," "Take that vacation you've always wanted," "You've earned it, now use your home for the good things in life you couldn't enjoy before," "Pay down your credit card balances,  buy a new car, consolidate loans - just 3.9 percent interest."

You've seen the ads. They're everywhere: radio, television, newspapers, and dinner-hour telephone calls. Lenders are pushing home equity loans with reckless abandon. Americans have encumbered themselves with more than $1 trillion in home equity debt. In fact, to call it home "equity" debt stretches the semantics because a growing number of Americans are now upside down with second, third, and sometimes fourth mortgage. Millions owe more than their home is worth. They're locked into debt for as far into the future as they can imagine.

The Wealth Destroyer

Just 25 years ago, most homeowners optimistically counted off the years and months that would pass before they were able to pay off their home loans. Take out a second mortgage (as home equity loans were then called) - unthinkable! Only dire emergencies could force such imprudent borrowing. That's why nearly all members of Tom Brokaw's the Greatest Generation crossed into retirement as homeowners free and clear.

From Fiscal Watchdogs to Selling Loan Products

Sometime in the mid to late 1970s, banks changed. Loans became products that banks  wanted to sell. They reversed their long-established role as fiscal watchdogs. Rather than counsel people against the evils of needless borrowing, bankers blitzed the public. Banks mass-mailed unsolicited credit cards to people they had never seen or heard of.

"Spend, borrow; borrow, spend," the bankers urged. "No credit, slow credit  bad credit, no problem. If you own your own home, we've got a loan for you. No equity needed." No wonder that bankruptcies have climbed to level 10 times higher than they were several decades ago. The loose-pocketed purveyors of credit are now reaping what they have sowed.

Weakness of Will and financial Discipline

In adopting the sales approach, the bankers knew their marks. They knew that millions of people would jump at the chance to spend and borrow now, and then think about the destructive consequences later. You may have read news articles that talk about "the shrinking middle class." In its place we're seeing great growth in families and households with little or no positive net worth. Quite the opposite is true, too-great growth in the number of people who are prospering. And no, income differences don't primarily explain the wide disparities.

What does account for these discrepancies? Danko and Stanley (The Millionaire Next Door) coined the terms UAWs (under accumulators of wealth) and PAWs (prodigious accumulators of wealth). The critical distinction: patterns of spending, borrowing, saving, and investing. On a scale of 1-10, UAWs score 8-10 on spending and borrowing; 0-3 on saving and investing. PAWs reverse those scores: 8-10 on saving and investing; 3-6 on spending and borrowing.

Just Say No

Home equity borrowing vanquishes your capacity to build wealth. If you do use it, use it only for productive investment that offers low risk for good returns. Never dine on seed corn. In contrast, the data on home equity loans overwhelmingly show that borrowers most frequently put these funds into consumption, including ill-considered home improvements.

What about bill consolidation, or paying off high-interest-rate credit card balances? Again, prudence says no.

Rather than paying less interest, this approach often leads to even larger amounts going to interest and higher amounts of debt. Why? Because borrowers who wrap their credit  card balances and other bills into home equity loans (or refinances) temporarily minimize the pain of debt. Yet, with a longer term and lower payments,  the debt generates higher long-term costs. Even worse, many borrowers run their credit card balances climb right back up to where they were previously. "Uh-oh, better up the home equity limit or refi again. Thank goodness the home went up $10,000 in value last year." Wealth destruction continues.

What to Look for in Home Equity Loans

If after careful review  of the numbers you still decide to load up your home with debt, at least closely examine the terms of your home equity loan (lump sum borrowing) or home equity line  of credit (spend your equity directly through the checks or credit card the bank gives you). borrow with the same savvy you would apply to any other home finance agreement that your would enter into, as discussed throughout Mortgage Secrets. After all, no matter what cute marketing terms the lender coins, a home equity loan carries the same types of terms, conditions, obligations, and rights of foreclosure as does any other mortgage.

No, let me revise that statement. Don't merely borrow with savvy; borrow with magnifying-glass scrutiny. Lender hype and fine-print gotchas multiply with home equity loans.

Most people pursue purchase mortgages or refinancing out of need.  These loans are bought as much as they are sold. Not true  with home equity loans. Ninety percent of the them, lenders sell these  loans. Relative to their dollar volume, lenders spend far more to promote and market home equity loans.  Also, predatory lenders stalk the jungles of home equity lending in fierce competition with other members of their species.

Specifically, here are several of the more important terms and conditions to watch out for:

• ARMs. Adjustable-rate mortgage account for most home equity loans. Scrutinize caps, adjustment period, and margins.
• Teaser rates. Nearly two-thirds of home equity loans start with teaser rates. How long will it last? How high can it jump?
• Prepayment penalties. Great teaser rates often come with prepayment penalties. Lenders don't want you to grab a below-market rate for three or six months and then bail out before they've extracted their pound of flesh.
• Balloon payment. When does the loan fall due? Is it callable prior to that date? If you want  to renew, must you re-qualify? Must the lender order a new appraisal?
• Garbage fees. Usually not as bad as with purchase/refinance mortgages, but some lenders will sting you if you're not swatting as necessary.
• Maintenance and  inactivity fees. Some borrowers set up home equity lines of credit only to be used in emergencies. The lender may require you to either borrow some stated minimum amount, or pay a fee for the privilege of refraining.

Note also that an open line of home equity credit - whether used or not - could reduce your credit score. If you plan  to refinance or buy another property anytime soon, weigh this borrowing within the context of your total credit profile. Might the credit scoring program judge you to be extending yourself too far?