The No-Equity Loan Trap

Don't fall prey to home-equity loans that allow you to borrow more than your house is worth.

THANKS TO SOARING home prices and the fantastic mortgage rates we've seen over the past few years, millions of homeowners have tapped their home's equity to pay off bills or fund a remodeling project. And in many cases, this can be a smart thing to do. But it's one thing to draw on the value of your home and another to exceed it. Falling prey to what's known as a "no-equity home-equity loan" not only could cost you a small fortune in interest rates and fees, but it could put your home at risk.

A no-equity home loan is 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 -- often by as much as 25%. This creates a sort of a hybrid secured/unsecured loan. Not surprisingly, these risky loans are aimed at the truly cash-strapped. And, sadly, that's a booming market. Indeed, loan originations for the so-called subprime market have swelled from $25 billion in 1993 to $187 billion today, according to SMR Research. That said, high LTV or no-equity loans still make up less than 10% of all home-equity loan originations.

No-equity home-equity loans were most popular back in the late 1990s, when many lenders boldly offered high-risk loans and borrowers felt comfortable taking on additional debt. More recently, rising home values and attractive interest rates for mortgage refinancing have helped even cash-strapped homeowners avoid such excessive borrowing, says Keith Gumbinger, vice president of HSH Associates. But these loans are still available from DiTech (a division of General Motors), Master Financial and E-Loan, to name a few. And experts say these loans will regain popularity as the economy rebounds, since lenders will once again be more willing to lend to riskier borrowers.

So what exactly is wrong with these loans? To start with, the interest rates are extraordinarily high. They typically run two to six percentage points more than the rates for traditional home-equity loans, according to HSH Associates. Then there are the fees, which are also higher than those for a traditional home-equity loan, Gumbinger says. Of course, just how much you'll pay depends on your credit history, the lender and the structure of the deal. (To get a sense of how much a traditional refi will cost you, see our worksheet.) In some cases, a high LTV loan is layered on top of an existing mortgage, which means the higher rate would apply only to the new loan. Other times the entire first mortgage is refinanced while the borrower takes on additional debt. In this case, the higher rate would apply to the entire loan.

And there's more: You'll also be required to carry private mortgage insurance (which typically tacks an additional 0.8% to your balance) on the amount of the loan that exceeds 80% of your home's value, but doesn't yet exceed 100%. (In other words, you'll owe PMI on 20% of the secured part of your loan.)

Other considerations are the tax implications -- or lack thereof. As you probably know, part of the beauty of a home-equity loan is that up to $100,000 of interest ($50,000 if you're married but filing separately) is tax deductible. But those rules don't apply to high LTV loans. Any interest paid for the amount by which the loan exceeds your home's value doesn't qualify for the tax break.

Selling your home may also pose a problem. 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. If you can't come up with the cash when you sell your home, your loan is effectively in default. And at that point you're probably looking at bankruptcy.

Bottom line? Don't get fooled by a sleazy sales pitch. "You want to be cautious about getting into these things because you literally may never be able to get out," Gumbinger says. 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 rather than getting a no-equity loan.