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Mortgage interest rates are at record lows these days, but fewer people than ever are qualifying for them, because of stricter lending standards at many banks. Thus, it's perhaps not much of a surprise that many folks are turning to home-equity loans for money. That's a double-edged sword, though -- presenting some danger for borrowers and banks alike.

There are some upsides to home-equity loans. For starters, if you really need access to some cash, they can be an effective way to get some. Secured by your home as collateral, they offer lower interest rates than those tied to unsecured loans, such as your credit cards. The interest you pay can also be tax-deductible in some cases.

But like regular mortgages, home equity loans leave you facing the risk that your home will lose value, and you can end up owing more than you'll get from the home if you sell it. Since your home is the collateral, you may end up losing it. And some such loans have unfavorable terms, sometimes charging you steep penalties if you try to prepay to save money. Adjustable-rate loans can suddenly present you with significantly higher and more costly rates. Finally, although interest rates for these loans are lower than many options, they're still much higher, on average, than mortgage and car-loan rates.

Banks at risk, too
Just as waves of mortgage defaults are hitting banks, home-equity loans are also potential hazards, sometimes seen as ticking time bombs. For one thing, they're not small sums. At two sample banks, for instance, the average home-equity loan or line of credit ran between $75,000 and $100,000.

And with unemployment remaining at very high levels and our economy in distress, a wave of home-equity defaults may be looming. In The New York Times, Gretchen Morgenson recently reported that even though most home-equity loans are seen as "performing," meaning that payments are arriving on time, those payments are often just for interest, leaving borrowers at risk of default later.

According to its most recent annual report, Citigroup (NYSE: C  ) sports more than $25 billion in home-equity lines of credit that are still in their revolving periods and therefore subject to drawdown by borrowers. In its most recent statement, Wells Fargo (NYSE: WFC  ) reported more than $100 billion in home-equity loans and HELOCs. JPMorgan Chase (NYSE: JPM  ) , in its most recent annual report, hinted at a possible developing problem, noting, "Weak economic conditions and housing price declines continued to drive higher estimated losses for the home equity and mortgage loan portfolios." At the end of 2010, the bank had about $113 billion in home equity loans outstanding. Also at 2010's end, Bank of America (NYSE: BAC  ) sported a whopping $138 billion in home-equity loans.

Our economy is not yet back on its feet. Thus, our own financial health and that of banks may be on somewhat shakier ground than we think.

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Longtime Fool contributor Selena Maranjian owns shares of JPMorgan Chase, but she holds no other position in any company mentioned. Check out her holdings and a short bio. The Motley Fool owns shares of Bank of America, Citigroup, Wells Fargo, and JPMorgan Chase and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On September 14, 2011, at 8:20 PM, garifolle wrote:

    I am wondering if one of the reasons why there are so many mortgage defaults could be linked to the fact that interests on mortgages are tax deductible in the US (I do not know any other country where that is possible), up to $100,000!

    Those interests are deductible even if the cash is not 100% spent on the house.

    So it is possible for someone to use the cash from his mortgage to pay for other goods (like cars mostly I guess), where the interests are not tax deductible.

    First this deductibility from the interests on a mortgage seems unfair to me, because all is a matter of choice with what you do with your money (or lack of it).

    Someone who choose not to own a house, but rather rent an apartment, and buy a car or a nice home theaters.

    This person will have to take a loan, of use his credit card where the interests are much higher, if not paid in time each month.

    So the home owner who is just rich enough to be eligible for a mortgage, (but not so super rich that he/she could pay everything cash) and uses the cash for something else, has a privilege that he/she might not well manage.

    This article, amongst other,

    The Tax Benefits of Home Ownership

    http://www.alllaw.com/articles/tax/article3.asp

    made me think that there are really 2 categories of citizens, in front of the tax law: the home owners and the non home owners.

    Maybe the law was made so in order to help as many Americans as possible to access to home ownership.

    But if the mortgage cash is used to buy washing machines, home theaters, or cars, this distort the intent of the law.

    And the banks take their advantages too: between "foreclosing" a car or a house, they certainly prefer the house.

    I live in Canada, my houses is fully paid, and I keep receiving offers for banks who would like me to take a mortgage (to the point that the offer to pay all the fees attached to signing a mortgage contract) so that I could use it to buy what ever I'd like.

    Except that here in Canada, not only the interests are not tax deductible, but the house insurances are higher is there is a mortgage on the house.

    Does this make sense?

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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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