The No-Equity Loan Trap

The truth is, these loans, which are basically home-equity loans with unsecured personal loans tagged onto them, are a lousy deal. Their high interest rates and outrageous fees will kill you.

And they haven't done much for Marino's FirstPlus Financial, either. That company, the leader in the market, filed for Chapter 11 bankruptcy in March 1999 and has been delisted by the New York Stock Exchange. So FirstPlus is no longer originating "no-equity home-equity" loans. But its biggest competitors, DiTech (a division of General Motors), The Money Store (a division of FirstUnion) and Master Financial, are keeping busy. The market for these no-equity loans is booming. According to Jeffrey Zeltzer of the National Home Equity Mortgage Association (NEHMA), the market is now 10 times the size it was four years ago. However, no-equity loans still make up less than 10% of home-equity loan originations.

What exactly is a no-equity home-equity loan? It's simply a confusing name for a high loan-to-value (LTV) home-equity loan, in which the amount you're borrowing surpasses your home's total value, usually by 25%, but in some cases, by as much as 50%. It's a sort of a hybrid secured/unsecured loan. The portion that is loaned up to 100% of your home's value is secured by your home as collateral and its interest is tax-deductible. The portion that goes above 100% of your home's value is unsecured, and is not deductible. And it's this unsecured portion that constitutes the "no equity" in a no-equity home-equity loan.

The loans are available to just about anybody. Americawide, a Crystal River, Fla., home-equity lender, promises what seems to be impossible: 150% LTV loans for borrowers with credit ratings as low as "C-," one notch above someone who's just declared bankruptcy. In this case, the borrower must pledge to put 25% of the loan proceeds back into the home in the form of certain improvements, such as a swimming pool or extra bathroom, and has to submit proof of this work to the lender. According to Americawide, this improves the chances of getting repaid. So, you get a marble counter-top. Big deal. You'll pay a mighty high price.

To start with, the interest rates on these no-equity loans are extraordinarily high. According to HSH Associates, they average between two and six percentage points higher than the rates for traditional home-equity loans. According to a 1998 study by the General Accounting Office, the average rate for no-equity loans was 13.5%, with an effective rate of 14.5% once all the fees were thrown in. And interest rates have risen since then. That compares with a current 8.9% rate for a traditional home-equity loan and 14.4% for an unsecured personal loan. Speaking of fees, a no-equity borrower will typically pay between five and 10 percentage points of the loan value to compensate the broker and lender, as well as closing costs of about $2,500 to $3,000. On the other hand, home-equity loans and personal loans from banks generally come without any additional "points." And only the home-equity loan has closing costs.

So don't get fooled by the advertising. Much of it is sugar-coated "just to get people in the door," says Bill Matthews, managing director at the Mortgage Asset Research Institute, a Reston, Va., firm that ferrets out mortgage fraud. In fact, the U.S. Department of Housing and Urban Development has proposed legislation to rein in the advertising of no-equity lenders. The new rules would require the lenders to do things like make cost information available sooner in the underwriting process.

Another trap for no-equity borrowers is the final sale of their home. Say you get transferred, and you've got $175,000 worth of mortgage and home-equity debt, but you can only sell your house for $145,000. You've got to come up with $30,000, pronto.

Bottom line? If you need to borrow more than the equity in your home, it would be cheaper for you to combine a traditional home-equity loan with an unsecured personal loan than getting a no-equity loan.

But, if, after considering all these negatives, you still want to take out a no-equity loan, do yourself a favor. Check out the lender. Make sure it is a member of NHEMA, which investigates potential members' advertising before allowing them in. And call your state's mortgage-licensing board to see if the lender is actually approved to sell the product you might purchase. Most of all, shop around. You might find lower rates at your local bank. For more information, see our stories, "Should I Consolidate?" and "How Much Is My Loan Costing Me?"