How Tapping Into Home Equity Is Like Pawning A Gold Necklace
It has occurred to me that tapping into one’s home equity can be like pawning a gold necklace, television set, or other personal item with resale value. Both involve using collateral, either to borrow thousands of dollars through a home equity loan or home equity line of credit aka HELOC – or to borrow $50 for a very short period of time. I think it is interesting to compare and contrast these two types of loans.
Similarities between home equity-based loans and pawnshop loans:
- The borrower offers an item of value (a gold necklace or a $300,000 home) as collateral for the loan.
- Transaction fees (such as appraisal fees, insurance fees, and closing costs) are added to the loan amount.
- Items and homes are appraised to determine their value; the loan amount is dependent on but not necessarily equal to this value.
- The borrower often uses the money to fund an expense that is unrelated to the collateral. (For example, the money is used to pay a utility bill or tuition expenses, unlike a car loan in which the borrower gets a loan to finance the purchase of the car. According to the Consumer Bankers Association in a Bankrate.com article, 40% of HELOCs and 44% of home equity loans were used for debt consolidation with 23-25% used to fund home-improvement projects, back in 2002.)
- Transactions are subject to federal and/or state regulations.
- If payments are not made according to the terms of the loan agreement, the borrower forfeits his/her rights to the item. (Since the pawnshop already has the gold necklace, it simply retains possession of the item; the traditional bank's or mortgage company's arrangement is more complex and varies by state but basically the lender could have some legal rights to force the sale of the home via a foreclosure, receive proceeds from the sale of the home, or keep demanding repayment after the house is sold if the sale doesn't generate enough funds for repayment).
- As long as each loan is paid back, the something (home or necklace) can be used as collateral again and again.
- The pawnshop customer relinquishes the personal item in order to obtain the loan but the home-equity borrower can still enjoy use of the home.
- The bank or mortgage company places a lien on the home to protect itself from losses; a lien provides the lienholder with the legal right to proceeds from the sale of the home.
- The home equity loan or HELOC interest rate is typically much lower than the pawnshop interest rate (for example, 6% for a HELOC vs. 24% for a pawnshop loan).
- Interest paid on the home equity-based loan is tax deductible with certain restrictions.
- Homeowners may be able to obtain a high LTV (loan-to-value) and borrow more money than the collateral (home) is worth. Pawnshop owners make loans for less than the resale value.
A few months ago, a soon-to-be-out-of-work mortgage broker enlightened me on how some homeowners use home equity to meet financial goals such as saving for retirement or paying for a child’s college tuition. I was fascinated by the idea that lenders championed equity-based loans as a savvy financial strategy so for the sake of equal time, I am proposing that these loans are similar to pawning what may be one's most valuable asset.
Source on Pawnshops: Brain, Marshall. "How Pawnshops Work." 23 August 2001. HowStuffWorks.com. <http://money.howstuffworks.com/pawnshop.htm> 31 July 2008. Note: I have a client who used to manage a pawnshop so I also learned about the process from him as well.