This afternoon I closed a home equity loan. Going through the often tedious process of complying with the Texas Equity Law (the A6 law) reminded me of at least part of the reason that Texas property values have remained more stable than those in many other parts of the U.S. Texas has reasonable regulation and enforcement of those regulations which protect consumers against some of their most ill-conceived ideas while still allowing them the freedom to make choices about their financial future and their real estate.
Texas was the last state to allow homeowners to borrow the equity out of their home. Texas is a homestead state, and the homestead laws provide a special layer of protection for homeowners. For example, a married homeowner cannot purchase a primary residence, refinance a primary residence, or sell the residence without his spouse's signature. This can sometimes pose problems since if couple's separate without divorcing, one spouse cannot purchase or sell his primary residence without involving the other spouse. In cases where an ugly divorce is underway, often the party who wants to purchase a new home has to wait until his decree of divorce has been signed by all parties and then the judge, but in most cases of amicable separation, one spouse will sign the deed of trust so that the other party can purchase their home.
The homestead law not only protects the interests of both spouses by preventing one from entering into a contract on a primary residence without the other party's permission, it protects the homeowner by preventing creditors for taking the home because of non-payment of non-real estate related debts. In Texas, the mortgage company can take your home if you do not make the payments, the IRS can take your home if you owe back taxes, and the county property tax office can take your home for failure to pay property taxes. Other than that, you are fairly safe. A judgment filed against you by your business partner for the money you owe him from your failed venture will not cost you your home.
Because of these protections, Texas lawmakers were careful when they drafted the home equity law in 1998. The A6 law--which takes its name from its amendment number to the Texas Constitution--was designed to protect the homeowner from himself. The law mandates that no homeowner may borrow more than 80% of the fair market value of his homestead for an equity loan. Since the fair market value can be established only by an appraisal, even during the height of lax guidelines, no property which was being underwritten for a home equity loan could use an appraisal waiver option. The appraisal had to be presented to the borrower not later than at closing so that he would have proof of the fair market value of his home.
Lawmakers were concerned with equity stripping, so they established a provision that all fees, including origination fees, third party fees for credit reports, and surveys, lender fees, and title insurance and title fees, could not exceed 3% of the loan amount. This fee cap did not apply to discount points paid to the lender, and it did not cover prepaids for escrows for taxes and insurance, or prepaid interest on the loan. This provision made it more difficult to do loans under $80,000.00. However, yield spread premium--the spread on the interest rate--which is paid by the lender to the originator, was not included, so the originator could still be compensated for his work. Borrowers understood that a cash out loan would carry a higher interest rate than a non cash out loan, but they also understood that the fees rolled into their loan had to be contained in the 3% cap, so they did not have to worry about their equity being eaten up by excessive costs.
Most interestingly, Texas mandated a 12 day disclosure form which the borrower and his spouse had to sign at application. This disclosure form listed for the borrower his rights under Texas law. His loan would never have a pre-payment penalty; he could not borrow more than 80% of his equity; his fees would never exceed 3%. A Texas cash out loan is recorded on a home equity deed of trust, and if that loan is ever refinanced, it must be also refinanced on a home equity deed of trust. Whether the borrower is taking out additional cash, or just reducing his interest rate and term, the provisions and protections of the original equity note apply--he can never borrow more than 80% of the value of his house, his fees can never exceed 3%, and he can never have a pre-payment penalty. A Texas home equity loan can be refinanced only once a year, so the borrower has to wait one year and one day before obtaining a new loan--even if no cash is being taken out of the house. Further, foreclosures on Texas cash out loans are judicial foreclosures.
The 12 day disclosure started a 12 day cooling off period. Loan docs could not be signed until the 13th day, and then the borrower entered another 3 day federally mandated cooling off period. If at any time during the cooling off period he decided to cancel the transaction, all fees paid to the loan originator, including the appraisal fee, had to be refunded to the borrower in full.
I entered the loan origination industry in 1998--the first year of the law. In fact, my first mortgage origination was a Texas cash out. I had never seen so many forms in my life! As I got to know other people in the origination community, I heard a lot of complaints about the new law--other states allowed the borrowers to borrow 100% or more of their property values. (In New Mexico in 1998, a homeowner could borrow 125% of their home's equity in cash!) Many people complained that the new law was too strict and that borrowers who really needed cash would have to sell their homes because they were too restricted in the amounts they could borrow.
A few years later, the Texas legislators returned to make some changes to the A6 law in response to demands for home equity lines of credit (HELOCS) which were becoming increasingly popular around the country. Texas did allow HELOCS, but only up to 80% of the property's fair market value. And even as they added the revolving line of credit as a lending option in Texas, they also added some additional protections. Now, in addition to waiting through a 12 day cooling off period before signing loan docs, the borrower had to review his HUD 1 settlement statement of closing costs and his final loan application 1 business day before closing. No changes could be made to the application or the settlement statement after the borrower's review, so this eliminated the possibility of changing any fees at the closing table.
And while a homeowner could get a line of credit against his house, he could not take a sum of less than $4000.00 at any one time, and he could not have credit card for his HELOC. This eliminated the possibility of spending one's home equity on fast food or a weekend trip to DisneyLand. By making the minimum draw $4000.00 and prohibiting credit cards for accessing the HELOC, the state sent a clear message that the equity in an individual's home is not to be frittered away on impulse purchases.
During the height of the real estate boom, we read about many homeowners who tapped and utilized up to 100% of the equity in their home. In states like California, Arizona and Florida, the appreciation was so rapid that the equity replenished itself like a magic elixir. But in Texas, and specifically in my market of El Paso, we never had great appreciation. I counseled many disappointed borrowers from other states that in our market, the property values remained fairly steady and they could not expect to see much appreciation in their homes for the first several years of their note.
But today in 2010, the wisdom the Texas home equity protection is clearer. By protecting borrower's equity, lawmakers protected property values for entire state. By requiring that borrowers who were cashing out maintain at least a 20% equity in the property, the state did not enable borrowers to end up "upside down" in their properties. It would be interesting to know how many of the borrowers nationwide who are choosing "strategic default" as an option for dealing with the fact that they are in an upside down equity position are in that position because of home equity loans and lines of credit.
"Lead us not into temptation," is a line from the Lord's Prayer. The truth is that most of us do not have the willpower to resist the impulse buy on credit, and if protections are not in place, Aunt Martha's home equity will be spent on a series of afternoon shopping trips and lunch with the girls. But the other truth is that people need flexibility to access their equity when they have a legitimate need or a desire to do something that could potentially better their lives.
That is what reasonable well-planned oversight and consistent enforecment does--it provides boundaries. It gives consumers the freedom of choice while acknowledging that not all choices will necessarily be positive ones.
As Congress wrestles with financial reform, maybe it should be using Texas as a model. Without reasonable oversight, we have financial chaos and widespread irresponsible behavior for which in the end all of us pay. But excessive and burdensome regulation kills opportunity, choice and freedom. A well-planned, consistently enforced regulatory model creates an environment in which businesses can prosper and consumers can thrive, and that is the kind of reform all of us should embrace.