Using Home Like A Piggy Bank – Borrowing Against Your Home

Using your home like a piggy bank is when you take out loans against your home. Borrowing against your home is easy, but has lots of implications. What are the issues? What do you need to know about the issues?

Homes Are Senior’s Castles

When it comes to aging, most seniors rank money as one of their greatest concerns. To fix money issues, many seniors are lured to their largest asset, their home, to meet their spending needs. Borrowing against your home can generate spendable money, but it comes with issues.

Your home is your castle, and as far as the banking system is concerned, it’s more than happy to use your castle as collateral for a loan. That means you can get an institution, and sometimes, individuals to pay you money in return for an ownership interest in your home.

Home Loan Basics

What you borrow from a bank needs to be repaid. Home loans are called “home loans” because they are collateralized against your home. If you don’t pay back what you promised, the bank can throw you out of your home, take possession, and sell it to get back what you owe them, plus their costs.

Seniors are susceptible to unplanned expenses. If you’re on a fixed income and your expenses go up, it’s easy to lose a house. Especially if you’re using your house as a piggy bank.

Costs Of Home Loans – Borrowing Against Your House

Let’s first cover the basics. Banks are businesses and when they make a home loan, they incorporate all of their costs in the fees and interest rate they charge the borrower. Anyone in the banking or lending business needs to cover all the costs listed below.

Costs Embedded In Your Home Loan

It doesn’t matter if the loan is reverse, forward, or upside down (that’s a joke). The point is that all the costs below are baked into any financial institution loan.

Standard Home Loans Versus Reverse Mortgage

A quick thought on reverse mortgages. From a cost perspective, a reverse mortgage is similar to a home loan or home equity credit line. The bank will charge its costs and put them into the loan. The key difference is that in a reverse mortgage the bank is taking the equity in your home and using it to make a monthly payment to you.

Therefore, once you decide you want to use your house as a piggy bank, know that “costs” are pretty much the same.

Cost Components Of Borrowing Against Your Home – How To Evaluate A Standard Home Loan

When you decide to borrow against your home, you should understand the components that a bank uses to price your loan. The key variables or features are described below.

Annual percentage rate

Annual percentage rates are what’s used to compare similar types of loans. Similar types would include types of credit card loans, or home equity credit line loans, or mortgage loans. Because each of these loans can have lots of different upfront and recurring fees, you need to lump those into your calculations. That’s what the APR attempts to do: account for all the fees and costs that vary between similar types of loans.

Type in, annual percentage rate calculator, into Google to get to a calculator. Make sure you include all fees and costs.

Repayment or Types of Mortgages

A good way to grasp types of mortgages or loans is to consider the following: the source of funding, borrowers’ preferences, and regulations. Borrowing against your home results in a type of loan.

Funding

Funding involves the source of funds that are used to fund the loan. To make you a loan, the bank needs the money for that loan. This is known as the source of funds. Funds can come from many places. Bank depositors’ deposits: the money the bank takes in for checking accounts, savings accounts, CDs, bond issuances, and other saving products.

If I fund a loan with two-year funds, the pricing of that loan (say the rate paid by the borrower) will be a spread over those two-year funds. If I use 10-year funds, the rate paid by the borrower will be a spread over those ten-year funds. Generally, the yield curve, the rate for or cost of funds on borrowed funds, increases over time. It’s cheaper to borrow for a year than it is for thirty years.

Loan Example

Here’s a simple way to conceptualize this process. Say you’re willing to give me $100,000 if I pay you 5% in interest each year and pay you back the $100,000 at the end of 10 years. I can then take that $100,000 and lend it for 10 years at 8% per year and demand repayment at the end of 10 years. I make the difference between 8% and 5%. I’m a banker. And my spread is the gap between the cost of my ten-year funds (the money I borrowed from you at 5%) and what I charge you (8% for the 10-year loan). We’re ignoring compounding, fees, and other costs, but they’re not needed for points in this post.

Funding Source

One last point about funding a loan. Best practice lending is funding a certain length loan with similar term sources of funds. That way a bank can lock in say a 10-year CD for 100,000 where it pays 5% and make a 10-year loan at say 8%. If rates go down and the borrower wants to prepay their loan, they do, and the bank now has the 100,000 it needs to pay back the CD borrower. Once funding sources and loans get mismatched bad things can happen. But they can almost always be fixed as long as loans are properly collateralized. That’s why in banking crisis, one of the first things that is done is to move good assets into one portfolio and bad assets into another.

Although there are many good reasons for funding loans with appropriate length funding instruments, it’s a best practice not always followed by banks. Because short-term loans are often very cheap, in environments when interest rates are flat or falling, swapping longer-term costly funds for short term cheaper funds can increase a lender’s profits. When the environment reverses itself, the opposite becomes true.

Borrower’s Preferences

People borrow against their home for many purposes. Maybe I want to buy a car, or a boat, or a house. If I don’t have cash, I need to borrow the money so the person selling me the car, boat, or house get’s cash for what they sell to me. That’s where banks come. They were created to make loans to facilitate transactions between sellers and buyers.

We discussed above what might be bank best lending practices: matching the length of a loan with an appropriate source of funds. But consumers have lots of preferences that have nothing to do with bank best practices. For example, as a consumer, I may want to borrow as much as possible and pay back as little as possible. That’s rational, but as I’ve shown above, across the life of a loan, all loan types and structures share similar costs. So rationally, I don’t really get a much better loan regardless of type. But I can get my preferences met if I am willing to be a little less rational.

Lowest Monthly Payments

Some borrowers want low payments, period. Borrowing against your home is one of the few lending products that will amortize over long periods of time. This tends to lower monthly payments. You know your monthly income and know you can only afford $300 a month for a car. If you want a $30,000 car, at a 6% interest rate the lender will need to structure a loan where you spend about 12 years paying off that car. Raise the rate to 12% and you’ll spend 30 years paying off the car. At 6%, over the 12 year payback period, you’ll be paying about $35,000 in interest payments. At 12%, over the 30 year payback period, you’ll be paying about $81,000.

Almost all “lowest monthly payment” loans fall into, or boarder, the category of “predatory lending.” That’s where the lender knows the borrower cannot afford what they are buying but is willing to devise a loan so they can collect enough payments at the high-interest rate combined with their confidence in repossessing the car so the overall transaction is profitable for the lender. Technically, predatory lending requires inadequate or false disclosures, abuse of risk-based pricing, and inflated fees and charges.

Credit Scores Matter

Here’s the deal: if you have perfect credit, major lenders (Credit Unions, National Banks, the largest bank or Savings & Loans in your community) will offer you great rates. If you have great to perfect credit and want the lowest rates from reputable lenders, Credit Unions and Costco are good options. Costco generally is the place to go. Costco has a history of doing a really good job at vetting vendors.

Regulations Effecting Borrowing Against Your Home

Banks were created to lend money. Historically, governments have had serious issues with banks. When they failed, people lost money, and borrowers were often asked to repay their loans and denied access to their credit lines. To mitigate these issues governments heavily regulate banks. Borrowing against your home has the most regulations. Anyone that lends is subject to regulations, and these rules generally follow bank regulations. Banks are regulated by the Bank Holding Company Act (BHC Act), the International Banking Act, the National Bank Act, the Federal Deposit Insurance Act (FDI Act), and state banking laws.

What Bank Regulations Require

These regulators impose strict requirements on the bank-consumer relationship. These focus on the rates they can charge consumers, disclosures to customers, documentation for loans, tying products together, and the qualifications of borrowers. On the bank side they focus on accounting, reserves, reporting, governance, and capitalization.

Since the financial meltdown of 2008, regulators have increased their vigilance. Many exotic lending products know no longer available. Most consumer loans are cookie-cutter and vanilla. See above.

Fannie Mae and Freddie Mac

Also contributing to the cookie-cutter nature of consumer lending is the tightening requirements of Fannie Mae and Freddie Mac. Created by Congress these entities support stability, liquidity, and affordability to the home mortgage market. They create liquidity (access to funds) to home lenders. These are the banks, savings and loans, and mortgage companies that make home loans to consumers.

They buy mortgages from lenders. Fannie and Freddie then can hold them, and benefit from the repayments, or package the loans into mortgage-backed securities (MBS) to sell. Lenders use the cash raised by selling mortgages to the Enterprises to engage in further lending. The packaging of mortgages into MBS (with Fannie/Freddie guaranteeing the timely payment of principal and interest) attract investors into the secondary mortgage market. This also increases funds for additional home lending because Fannie/Freddie can use this money to buy more lender originated home loans. All these transactions and liquidity makes the secondary mortgage market more efficient and equitable, and if done properly less costly to borrowers.

Fannie & Freddie Buy Bank Originated Loans

For lenders, Fannie/Freddie offer an immense opportunity for maximizing profitability. Wih Fannie and Freddie, a lender can make decisions about if, how and when to manage their loans. Banks can portfolio or sell their originated loans; they can rely on Fannie/Freddie for funds to pursue additional or different bank product strategies and tactics (i.e., they can sell originations and use those funds for other banking activities).

Here’s the catch: Fannie/Freddie only buy qualifying loans. Loans that meet their strict underwiring and type requirements. Since the financial crisis of 2008, the type of loans they’re willing to buy has narrowed. This means the variety (types) of loans available to consumers has gone down.

Other Resources For Borrowing Against Your House

Also see our Mortgage Section – here.

There is a great loan calculator here: