March 1997

Rich House, Poor House:
The Two Faces of Home Equity Lending

This article was written by the Consumers Union Southwest Regional Office.

This year the 75th legislature is considering, for the sixth consecutive session, bills to send a constitutional amendment to the voters designed to expand home equity lending in Texas. The Constitution currently prohibits the forced sale of a homestead except for delinquent taxes, failure to repay a first mortgage, or failure to repay a home improvement second mortgage. Texans who borrow to finance college tuition, health care, automobiles, or other consumer goods, and cannot repay their loans, might damage their credit rating or lose the item they purchased but they currently do not lose their homes.

Benefits of Home Equity Lending

In other states, where home equity lending has grown rapidly over the past two decades, borrowers frequently benefit from access to the equity they have in their homes. The home is often a person's largest and most important asset. Home equity is the difference between the market value of the home and the amount owed on existing mortgages. Over the years, as homeowners pay down their debt, the home equity represents savings they might want to use for a variety of purposes.

In most states, consumers may borrow against the equity they have in their homes either through a home equity line of credit (an open ended account that consumers may use as needed) or a closed-end home equity loan for a specific purpose and with a formal repayment schedule.

A loan secured by a lien against equity (an additional lien or claim on the house itself) is considered a relatively safe loan by many banks because the home is a valuable asset and consumers will prioritize loan payments they need to make to prevent foreclosure. Lenders typically offer home equity lines of credit at a lower interest rate than consumers get through credit card companies. Currently, banks charge on average about 15.4 percent (APR) for a credit card,¹ while offering home equity lines of credit at the substantially lower average rate of 9.2 percent (APR).² At the same, consumers may deduct the interest on home debts from federal income tax. For consumers who deduct (29% of all taxpayers deduct)³, this lowers the effective interest rate on these loans even further.

A reverse mortgage is another form of home equity loan that benefits some older borrowers. Many elderly Texans own their home, free of any mortgage. Under a reverse mortgage, a bank offers the homeowner monthly cash payments and places a new lien on their home. In many cases, no payment on the new debt is due until the homeowner dies or sells the house. The loan advances from a reverse mortgage are not taxable and do not affect Social Security, Medicare or Medicaid eligibility as long as the borrower spends the money within the month received.

While Consumers Union generally supports consumer access to home equity, many protections will need to be incorporated into the Texas lending market to prevent abuse. In a fragmented loan market, where some lenders offer loans only to higher income preferred borrowers while others target lower income and older borrowers with less advantageous loans, some Texans might find themselves unexpectedly homeless without the protection currently afforded by the Homestead Act.

The Two Faces of Lending

While most Texans who will benefit from expanded home equity lending will borrow from banks, these institutions increasingly limit who they serve. Throughout the 1970s and 1980s the number of households without bank accounts, and therefore without direct access to the payment and credit services of mainstream financial institutions, increased. In 1977, 9.7 percent of families did not have a bank account. By 1989 the share of households without a bank had increased to at least 13.5 percent.⁴ According to a 1988 GAO study, as many as 17 percent of families did not have a bank account by the end of the eighties.⁵

The decrease in bank account ownership may be attributed to higher fees for small accounts and to the general withdrawal of FDIC insured financial institutions from low income areas. While higher low balance fees, bounced check fees, and withdrawal fees made accounts less affordable, several recent studies of bank presence in low income and minority areas confirm that banks in the 1980s withdrew from certain lower income and minority areas by closing branches in some cities.⁶

Particularly in Texas, the number of branch banks in low income and minority zip codes decreased significantly between 1985 and 1993, according to a recent Texas A&M study. Using data for branch bank and savings and loan locations in Texas, researchers found that the number of branch banks in high income zip codes statewide (the highest income quartile zip codes) remained constant over this period, but declined by 11 percent for low income zip codes (the lowest income quartile areas). Further, predominantly white zip codes statewide experience a 4 percent increase in the average number of branches, while minority zip codes experienced a decline of over 10 percent.⁷

As traditional banks moved out of low-income areas, alternative lenders, including pawn shops and finance companies, moved in. Beginning in the mid 1970s, so-called fringe banking services (finance companies, pawn shops, check cashing services) began to grow throughout the country. There were more pawn shops per capita by 1994 than at any time in U.S. history. The number of check cashing outlets more than doubled between 1989 and 1994.⁸

By the close of the eighties non-bank lenders accounted for nearly 30 percent of traditional (closed end) home equity lending, and served borrowers with lower income levels and less equity in their homes. According to the 1993-94 household survey, the average family income of home equity borrowers at finance companies was $46,000, compared with $59,000 at commercial banks and savings institutions. Finance company borrowers also typically had less home equity than depository institution borrowers: $39,000 compared with $97,000.⁹

Lower income borrowers do not generally benefit from the lower interest rates and easy terms of a home equity line of credit. Home equity credit lines are most often offered by large commercial banks to their preferred borrowers, and far less often to lower income borrowers. A recent Federal Reserve study concluded, "Homeowners who have a home equity line of credit typically own more expensive homes, have higher incomes, and have accumulated substantially more equity in their homes than other homeowners...They also tend to be somewhat better educated. For these reasons, a home equity line of credit is often characterized as an 'upscale' product."¹⁰

Lower income borrowers served by finance companies are frequently offered a closed end loan--for a preset amount over a contracted term--at higher than standard interest rates¹¹ even though studies indicate that lower income consumers do not default more than higher income borrowers.¹² According to the 1994-1995 Factbook of the Mortgage Insurance Companies of America, "Studies show that when low- and moderate income people have the opportunity to own a home, they will go to great lengths to pay their bills on time. MICA data shows that families who buy less expensive homes tend to default less than those who buy more costly homes."¹³ A 1993 study examining the performance of community reinvestment loans also came to a similar conclusion. ¹⁴

While low income people who borrow from non-bank lenders frequently pay higher interest rates, they typically do not itemize their taxes, so they gain little benefit from the deductibility of their new debt. Only 18.2 percent of Texas filers take any tax deductions currently, and only 15.7 percent deduct interest. Low and moderate income Texans rarely deduct interest (7.2 percent of filers earning less than $50,000 adjusted gross income deduct interest, and only 3.4 percent of filers earning under $30,000 deduct interest).

Although increased access to home equity loans might encourage more Texans to deduct, the overall numbers of low and moderate income people who choose to do so is likely to remain low. Although every state but Texas allows greater home equity lending, national tax statistics confirm that the tax benefits fall mostly to upper income families. Nationally, while 29 percent of all taxpayers deduct, only 13.5 percent of filers earning less than $50,000 adjusted gross income deduct mortgage interest, and only 6.5 percent of those earning less than $30,000 deduct mortgage interest. ¹⁵

Home Equity Lending Abuse

Public hearings before the U.S. Senate Committee on Banking, Housing and Urban Affairs in 1993 and 1994 brought problems in home equity lending to the front pages of the nation's newspapers. Consumers testified about their experience with a number of different home equity scams, most involving loans at high interest rates with excessive brokerage fees, and in amounts far in excess of the value of the home improvements the loans were supposed to finance. Estimates in the early 1990s indicated that more than 100,000 homeowners in 20 states nationwide lost most or all of the equity in their homes because of home repair and home equity lending fraud. ¹⁶

Many consumers testified to fraudulent marketing practices that saddled them with much larger loans than they needed for their purchases. Mr. D., 95, and his wife Doris, 82, lived in Los Angeles on a small fixed income. Mr. D. had no formal education and was mentally incompetent. With the help of a loan broker, the couple consolidated and refinanced credit card debt, existing home improvement loans and a new bathroom under a new $30,000 home improvement loan. The couple only needed $15,000, but the broker kept the rest for brokerage fees. By the end of the process, Mr. and Mrs. D. had liens on their home totaling $92,000 and a new loan they could not afford to pay. The lender foreclosed. ¹⁷

Though they were able to save their home with legal help, most of those testifying before the Congressional committee were not. One woman who lost her home closed her testimony by saying, "I hope that the United States Congress can do something to protect people like me whose only mistake was to trust people who sounded honest." ¹⁸

Lawsuits have been filed in more than 21 states against lenders associated with fraudulent home equity loans. One of the largest and most publicized settlements involved Fleet Finance of Georgia. In December of 1993, the company agreed to a settlement of up to $115 million for allegations from 18,000 borrowers.¹⁹ Jury verdicts in Alabama against Union Mortgage reached $57 million in 1991; a Ford subsidiary paid nearly $3.4 million to settle claims in Arizona, and Chrysler First, a subsidiary of NationsBank, had jury verdicts in Alabama reaching $2.15 million.²⁰

Predatory second mortgage lending in Texas occurs despite Constitutional protections, because Texans may already use their home as security for home improvement loans. In a national survey of Legal Aid attorneys conducted by the non-profit consumer organization Public Citizen, the Texas office had the largest number of home equity lending scams relative to other states surveyed. One Dallas legal aid office reported 764 home-improvement-related cases of second mortgage lending fraud over a five year period. ²¹

According to plaintiff's attorneys and lawyers with the Attorney General's Office, home equity lending fraud proliferated during the economic downturn of the mid to late eighties. Typically, loan brokers and contractors solicited elderly and low income consumers in their homes, offering pre-approved loans for siding, home repairs and other work and sometimes offering to rebate cash back to the borrower. A short time later, these homeowners found themselves deeply in debt, with high interest loans and repayment terms they could not afford, while the contractors walked away from unfinished or poorly finished jobs.

Between 1988 and 1990, consumers in both Travis county and Dallas county sued Goldome Credit Corporation after the lender attempted to foreclose on their homes. According to the complaints, Goldome Credit offered home improvement loans in excess of the value of the work, and then foreclosed on the homes even if the work had not been completed as promised. In one case, Goldome allegedly initiated foreclosure even though the consumer had already repaid the debt in full.²² Other such cases are illustrated throughout this report.

Foreclosure

Most concerns about increased home equity lending are grounded in the possibility that more individuals overwhelmed by debt might lose their homes. In Texas, where foreclosure is simple for the lender--and consumers have only a twenty day period to cure their default prior to posting the notice of sale--these concerns may be very real.

In this state, lenders may foreclose on a home using the "power of sale" granted under the mortgage or deed of trust. The loan papers grant the lender the right to sell the property on the courthouse steps after giving notice as required by state law. Texas requires lenders to notify the borrower at least 41 days prior to the sale. The first notice gives the borrower 20 days to cure the default. The second notice, provided 21 days before the sale, informs the borrower and the public of the date and time of sale.²³ If the homeowner cannot pay the past due amount (plus interest but not including future or accelerated payments) within the twenty day period, the sale may go forward. The homeowner must file suit and request a court injunction to stop the sale if they believe that extenuating circumstances, like an abusive home equity loan, should be considered.

Several common foreclosure reforms adopted in states across the country would give Texans who face foreclosure additional protection. At least 13 states require lenders to file a court action to obtain a judge's order authorizing a foreclosure sale, a process called judicial foreclosure. At least eight states allow the homeowner to redeem the home within a specified time after the sale by paying the purchase price plus interest and costs. Several state extend the time period during which the homeowner may get current (cure the default), both providing more notice and allowing the homeowner to cure the default right up to the day of sale.²⁴

All states have a process for judicial foreclosure, and in about half the states mortgages are always foreclosed by judicial action, either because of state law requirements or local custom.²⁵ In judicial foreclosure states the lender must file an action in court to obtain a judicial decree authorizing a foreclosure sale. Generally the lender must prove that there is a valid mortgage, the borrower is in default, and the proper procedure has been followed. The homeowner then has the opportunity to raise procedural and substantive defenses, such as fraud, usury, tender of payment, or Truth in Lending violations.

Some states, both states with judicial foreclosure and those without, also provide for a right of redemption, either before or after the foreclosure sale. While few financially distressed homeowners are able to redeem their homes, the right gives them the chance to either sell the home to pay off the debt, refinance the debt or pay the back payments in bankruptcy.²⁶ In at least 10 states homeowners may repay the debt within a specified time--anywhere from three months to a year-after foreclosure and gain possession of their homes again. Oregon requires the borrower to pay only the amount of the successful bid at foreclosure, rather than the full amount owing on the debt, plus nine percent per anum interest from the date of sale.²⁷

Some states have also enacted anti-deficiency statutes which prohibit or limit deficiency claims against the former homeowner. Most states, including Texas, limit deficiency judgments by requiring that the borrower be given credit for the "fair value" of the property after foreclosure. Some states limit the time period during which the lender can pursue a deficiency (Connecticut and Idaho).²⁸ Others (Alaska and California) ban deficiency judgments outright when mortgages are foreclosed non-judicially.²⁹

Federal Reform

In response to the growing publicity of predatory home equity lending, the U.S. Congress passed the Home Ownership and Equity Protection Act (HOEPA) of 1994. Signed into law on September 23, 1994, and effective October 1, 1995, the Act applies to closed-end home equity loans--also called traditional home equity loans--that meet one of the following criteria:

• the annual percentage rate is more than 10 percent above treasury bonds of a similar maturity period. (This rate can be reduced to 8 percent or increased to 12 percent as the Federal Reserve Board deems necessary.); or
• the up front points and fees exceed the greater of 8 percent of the total loan or $400.

The Act prohibited or limited the most common lending abuses, for the types of loans to which it applies. The Act:

• prohibited prepayment penalties unless the lender could show that the monthly payment on the debt is less than 50 percent of the borrower's monthly income based upon a signed financial statement, credit report, and employment wages, or additional income records, and prohibited loans extended without regard to the borrowers ability to pay;
• eliminated balloon payments for loans with a term of less than five years;
• prohibited negative amortization;
• limited interest rates charged after default to the rate that applied prior to default and created minimum standards for the calculation of interest rebated to the consumer if the loan is accelerated;
• required payments to be made to the borrower or through a third party escrow agent. The lender cannot make payments directly to a home improvement contractor.
• allowed the borrower to raise claims against the purchaser of their loan if it can be shown that the purchaser could reasonably have known that the loan was covered under this Act.³⁰

The Act also mandated a creditor disclosure specifying that the borrower is not required to complete the agreement merely because he or she has signed an application; that upon acceptance of the loan, the lender will have a mortgage on the borrower's home; and for fixed loan rates, the annual interest rate and monthly payments must be stated.³¹ The Federal Reserve Board must hold at least one public hearing within three years of enactment to evaluate its success, and solicit input from consumers, particularly low income consumers.³²

Though the HOEPA will discourage some home equity abuse, it applies its protections to loans with the highest rates. Some of the consumers described throughout this report borrowed at interest rates that would fall just below the trigger (currently about 16 percent depending on the maturity of the note³³). The provision prohibiting loans with monthly payments greater than half a borrower's monthly income is a protection of central importance, but in order to sustain an allegation that the lender has made an excessive loan to a particular borrower, the borrower must prove that their loan was part of a larger scheme to defraud many borrowers. Such a search is expensive, time-consuming, and likely to be beyond the ability of the average person.³⁴ It is critical, then, that states fill in where the national law does not protect borrowers, particularly those who are low-income and elderly, from unscrupulous lenders and home equity scams.

Unfortunately, the United States Congress over the past two decades adopted legislation to limit states' authority to enact consumer protections. A 1980 federal banking package (called the Depository Institutions Deregulation and Monetary Control Act of 1980, or DIDMCA) preempted all state usury laws capping interest rates on mortgages.³⁵ Intended to apply only to first mortgages, loan companies found that they could use this law to escape caps on second mortgages by refinancing a consumer's total debt into a new first mortgage.³⁶ DIDMCA also preempts state usury law if a person who owns their home outright borrows against it, creating a new 'first' mortgage.

Congress allowed states to "opt-out" of DIDMCA, but Texas had no reason to, since Texas' Constitution already limited liens on homesteads. While the opportunity to opt out of federal interest rate pre-emptions expired April 1, 1983, Texas still may opt-out of the federal preemption on points and other charges.³⁷

Congress also pre-empted state laws regulating the structure of a mortgage when it enacted the Alternative Mortgage Transactions Parity Act, or AMPTA. For example, state laws which limit variable interest rates, final "balloon" payments, prepayment penalties, or negative amortization are no longer enforceable, and AMPTA applies equally to first liens and any additional liens. Texas could have opted-out of the federal preemption in this area if it had done so by October 15, 1985.

Although these federal laws pre-empt state action, Texas can opt out of some provisions, and it may be possible for the state to circumvent others by limiting valid liens to those securing equity loans that meet specific criteria.

Endnotes

1. Federal Reserve Statistical Release,G.19 Consumer Credit, December 6, 1996.

2. Bank Rate Monitor, January 20, 1997.

3. Internal Revenue Service, Statistics of Income Division, Individual Income Tax Returns 1993, IRS Publication 1304, March 1996, Table 1.2.

4. John P. Caskey, Fringe Banking, p. 86. Citing Caskey and Peterson (1994) based on the Federal Reserve Board's 1977 and 1989 Survey of Consumer Finances. Because the two survey's treat wealthy families differently, the percentages cited are a percent of families earning less than $35,000 in 1976, or less than the equivalent of $83,780 in 1991 dollars. Fewer than 10 percent of U.S. families had incomes above $80,000 in 1991.

5. United States General Accounting Office. Government Check Cashing Issues. Washington, DC: U.S. GPO, 1988. Based on 1985 Bureau of the Census data.

6. Robert B. Avery, "Deregulation and the Location of Financial Institution Offices." Federal Reserve Bulletin (February 1986), and John Caskey, "Bank Representation in Low-Income and Minority Urban Communities." Urban Affairs Quarterly 29(4) (June 1994): p. 617 et seq.

7. Bierman, Leonard and Donald R. Fraser, Javier Gimeno, and Lucio Fuentelsaz, "Regulatory Change and the Availability of Banking Facilities in Low-Income Areas: A Texas Empirical Study," SMU Law Review, Vol 49, No. 5, p. 1438.

8. Casky, p. 36.

9. Glenn B. Canner, Charles A. Luckett and Thomas A. Durkin, "Home Equity Lending: Evidence from Recent Surveys," Federal Reserve Bulletin, July 1994, p.572-3.

10. Canner, p. 574.

11. Long, John B., Thomas W. Tucker, and David E. Hudson, Testimony Before the United States Senate Committee on Banking, Housing and Urban Affairs, pp. 1, 3, 9-11 and sample loan documents attached. Also Davis, Eva L., U.S. Senate Banking Committee, February 17, 1993, Statement of Eva L. Davis and attached loan documents. See also sidebars.

12. Avery, Robert, et al, "Credit Risk, Credit Scoring, and the Performance of Home Mortgages," Federal Reserve Bulletin, July 1996, p. 639. P. 633. "The relationship between borrower income and loan performance appears to be slight" Avery noted that loan-to-value ratio is a better predictor of foreclosure risk than income or even credit history. Also Mike Hudson, "Borrowing Trouble: Trail of the Tin Men," Roanoke Times and World News, December 10, 1994.

13. 1994-1995 MICA FACTBOOK, Mortgage Insurance Companies of America, p.13.

14. Sound Loans for Communities: An Analysis of the Performance of Community Reinvestment Loans, The Woodstock Institute and the National Association of Affordable Housing Lenders, October 1993.

15. Internal Revenue Service, Statistics of Income Division, Individual Income Tax Returns 1993, IRS Publication 1304, March 1996, Table 1.2.

16. "Fraud Growing in Lending Push on Home Equity," The New York Times, October 13, 1991. p.1.

17. Norma Paz Garcia, Dirty Deeds: Abuses and Fraudulent Practices in California's Home Equity Market, Consumers Union of the U.S., Inc., West Coast Regional Office, October 1995, p.19.

18. Louis Croisier, "Home Equity Scams Foreclose on the American Dream," Public Citizen, Summer 1994, p.11.

19. Croisier, p.12.

20. Mike Hudson, "Borrowing Trouble: Trail of the Tin Men," Roanoke Times and World News, December 10, 1994.

21. Stealing the American Dream: a survey of legal aid attorneys on abusive home equity lending, Public Citizen, Washington, D.C., 1994, p.27.

22. Plaintiff's Original Petition, Mary Leftwich Pritchett vs. Goldome Credit Corporation, Cause No. 90-10641, September 5, 1990. Settled out of court.

23. Texas Property Code Sec. 51.002.

24. National Consumer Law Center, Repossessions and Foreclosures, 1995 and 1996 Supplement, Appendix E, Summary of State Foreclosure Laws.

25. Ibid, p. 363.

26. Ibid, p. 426.

27. Mixon, John, "Deficiency Judgments Following Home Mortgage Foreclosure," Texas Tech Law Rev. Vol. 22, No. 1, 1991, p. 31.

28. Conn. Gen. Stat. Sec. 49-14; Idaho Code Sec. 45-1512 (action for deficiency judgment must be brought within 3 months of sale). Texas gives lender two years after the sale to pursue a deficiency judgment against a borrower.

29. Alaska Stat Sec. 34.20.100 (1990); Cal Civil Code Sec. 2924. 30 15 U.S.C. 1602 (aa) et seq. and 60 Fed. Reg. 15,467-15,473.

30. 15 U.S.C. § 1602 (aa) et seq. and 60 Fed. Reg. 15,467-15,473.

31. H.R. 3474 Sec. 129(a)

32. The National Consumer Law Center, Truth in Lending, Third Edition, 1996, p.503.

33. Estimate based on Federal Reserve Statistical Release H.15, Selected Interest Rates, February 24, 1997.

34. The National Consumer Law Center, Truth in Lending, Third Edition, 1996, p. 516.

35. DIDMCA overrides state laws which limit "the rate or amount of interest, discount points, finance charges, or other charges" on loans secured by a first-lien on residential real estate (DIDMCA § 501(a)(1)). From Usury and Consumer Credit Regulation, p. 41.

36. Hudson, Mike. "Stealing Home: How the Government and Big Banks Help Second Mortgage Companies Prey on the Poor," Clearinghouse Review, March 1993, p. 1480.

37. Usury and Consumer Credit Regulation, p. 53.