Addiction and The Current Substance of Choice   

I was talking with a friend the other day and the topic of substance abuse came up. He responded how that has changed in our upwardly mobile society. In the old days the substance of choice was alcohol. As drugs became popular, it was marijuana, then cocaine, then who knows. We talked about addiction today and we concluded that the current substance of choice is raiding home equity.

According to FreddieMac studies, most refinances in the last few years involved taking money out of the built-up equity in the homes. In other cases people are taking out a HELOC, a Home Equity Line of Credit. Economists say it's a good thing too, because the consumers took that money and spent it, thus keeping our economy from sinking into a recession following the dot com implosion. Maybe, maybe not. We may never really pin that down.

What we can pin down is that too many Americans are credit-junkies and if you make it easy for people to get their hands on money, they will take it and worry later about how to pay it back.

I am critical of the banks that are spending a ton on consumer advertising that basically scolds them for having "unused equity" in their homes! There is nothing wrong with "unused equity!" It's called wealth, part of your net worth. These banks also have an investment department that helps rich people accumulate and invest money so as to make them wealthier. And then there's the other department trying to make them poorer! You can argue that these departments have separate target markets, and I would agree. The problem is regular people will never become wealthy if some bank is always pandering to their baser instincts.

With interest rates having gone up, there is now another problem. When prime rate was 3%, the payment on that equityline was pretty low, say $125 per month on a $50,000 loan. Now with prime at 6.75%, the payment would be $281, and most people are paying something over prime rate!

I believe that HELOC's are good for some people and have done a number of them myself. We have also done cash-out refinance transactions, but I always try to counsel people not to take any more out than they need for some definable purpose. Let's talk about good and poor uses of funds.

Some clients want to improve their homes and need cash to finance the improvement. Projects like modernizing a bath or kitchen adds value to the home.

Other clients with lots of equity in their homes have taken the cash to use as a down payment on a

second home or an investment property.

Still other clients have two kids in college and tap the equity to make up for cash flow shortages when the tuition is due.

Some clients pay off higher interest rate debt such as credit cards or car loans. The rate is lower and for most people the interest is tax deductible. The important thing here is that I always work out a payment schedule with clients who do this. We want that debt to disappear in the future.

Usually they pick a period such as four years, and I work out the payment that would pay the line off in full.

There are some poor uses though. I have one client who paid off credit cards and then came back three years later with the same equityline balance and huge balances on all the credit cards again.

Frankly, I think that is a credit addiction problem.

Even worse is the story of a friend's mother who has done several refinances to the tune of $100,000 cash out and has blown the money gambling. She has a gambling addiction problem, not a good idea for someone on Social Security. In both these cases, the availability of easy credit HELOC's and cash-out refinances have made it easy for these people to feed their addiction.

Finally, I ran across a new one today. A man with an expensive home that he used to own free-and-clear was talked into getting a $2.5 million loan to invest in a bond fund. The yield was purported to be 8%, and was allegedly "risk-free." The loan payment is only 1% so it appeared as if he has a net spread of 7%. But in reality the real cost of this mortgage is 5.5% so the spread is only 2.5%. Even worse, all of the income will be taxable and the loan interest on everything over $1,000,000 isn't tax deductible. When you consider all the factors he may have a real return of only 1% or so, not enough to warrant the risk. The bond fund salesman and the mortgage broker were happy though, because each made huge fees and they took no risk at all.

Bottom line, whether a HELOC or cash-out refinance is good for you or bad depends entirely on the use to which you put the money. But I would weigh such a transaction carefully and review it with your advisor, such as your CPA.

Be careful out there!