The first prohibition on the forced sale of homesteads in Texas appeared in Texas statutes in 1839, before the state joined the union. This statute was adopted in reaction to a nationwide economic depression which became known as the Panic of 1837, when many families lost their farms and homes through foreclosure.
In various forms, this protection from foreclosure has been retained in Texas law and now resides in Texas' constitution in what is termed Texas' homestead law. Under the Texas Constitution, a Texas homestead may be foreclosed upon only for non-payment of the mortgage used to initially purchase the property, non-payment of property taxes on the homestead, or non-payment of a debt incurred to physically improve the property.
It is important not to confuse the homestead protection offered by the constitution with the homestead exemption from property taxes offered by many local taxing jurisdictions. The homestead protection embedded in Texas' constitution prescribes the limited conditions under which a lender may foreclose on a Texas homestead. The homestead exemption merely reduces the taxable value of Texas homesteads and is not a provision in the constitution.
Today, because of changes in federal tax law and banking practices, Texas' constitutional homestead protection provision also limits access to low cost and tax deductible financing options for both Texas consumers and small businesses.
If Texas were to change this provision to allow businesses and consumers access to the accumulated equity in Texas' homesteads, consumers could save as much as $225 million in annual interest payments. In addition, because home mortgage loan interest is tax deductible, they would also be able to reduce their federal taxes by as much as $99 million per year. Interest costs to businesses would fall by $58 million annually and small businesses would gain access to $375 million in loans to found and expand entrepreneurial activity.
If the average Texas homeowner were to just replace existing borrowing needs for new cars, trucks, boats, educational and medical expenses with home equity financed borrowing, they would save as much as $490 in interest costs and $360 in federal income taxes annually.
Home Equity in Texas
Accumulated equity in homes in Texas is one of the largest components of the wealth of Texans. As detailed in Table 1, in 1990, it is estimated that the value of owner-occupied housing in Texas reached $220.4 billion, or 4.7 percent of the total value of owner-occupied housing in the nation. Some of this value actually represents existing mortgage debt, and not equity.
Because Texas' population is somewhat younger than that of the nation and has therefore had less time to pay down mortgages, mortgage debt in Texas amounts to an estimated 44.0 percent of the value of homes in the state, somewhat higher than the 36.7 percent for the nation. Interestingly, according to the U.S. Department of Commerce, about one-third of the owner-occupied housing units in Houston in 1991 had no outstanding mortgage owed, indicating 100 percent equity. Table 1 indicates that total home equity in Texas in 1990 amounted to $123.4 billion.
But this store of wealth in Texas differs from many other assets in that it cannot be readily tapped to underwrite loans, to purchase goods or services or to repay other debt. Under the Texas constitution, a homeowner's residence cannot be mortgaged for purposes other than financing the purchase of the home, paying property taxes due on the homestead, or financing permanent improvements to the property.
Because of this limitation, Texas is the only state in the nation in which financial institutions cannot offer consumers the option of tapping into their home equity to pay for educational expenses, medical costs, consolidation of other debts or the myriad other uses found for home equity loans in the other 49 U.S. states. In these states home equity is widely accepted as collateral, and in recent years homeowners have raised substantial funds by borrowing against the equity in their homes. According to the Federal Reserve Board, the total value of home equity loans reached $255 billion in 1993, without substantial participation from Texas homeowners.
1990 Value of Owner-Occupied Housing and Home Owner Equity in the U.S. and TexasOccupied Percent Median Value Estimated Loan Value Estimated Housing Units Owner Owner-Occupied Total Value as Percent Total Equity (millions) Occupied Units (billions) Market Value ($ Billion) United States 91.947 64.2% $79,100 $4,669.3 36.7% $2,955.6 Texas 6.071 60.9% $59,600 $220.4 44.0% $123.4 Sources: U.S. Bureau of Census, 1990 Census of Housing, Detailed Housing Characteristics, Series CH-2, Census of Population and Housing, 1990: Summary Tape File 3C on CD-ROM. U.S. Department of Commerce, U.S. Department of Housing and Urban Development, American Housing Survey for the United States in 1991. Loan value as percent of market value for Texas estimated from American Housing Surveys for Dallas, Fort Worth-Arlington, San Antonio and Houston covering years 1989 to 1991.
The National Home Equity Market
The growth of home equity credit in the U.S. gained momentum in the mid-1980s with a boost from the Tax Reform Act of 1986. Importantly, this change in federal tax law mandated the phase-out of federal income tax deductions for interest paid on non-mortgage consumer debt, such as car loans, educational loans and other debt. This change in federal tax law enhanced the attractiveness of using debt secured by homes to fund expenditures that consumers had previously financed by other forms of consumer credit.
In a 1993-94 survey conducted by the Federal Reserve Board of the use of home equity loans , about one-third of homeowners cited its favorable tax treatment as an advantage over other types of loans. Nearly 13 percent of all homeowners in the U.S. held some form of home equity credit in 1993, up from 11 percent in 1988 and only 6.8 percent in 1983.
Largely as a result of the changing tax advantages, a new type of home equity loan instrument has seen substantial recent growth. The traditional home equity loan is a closed-end loan that generally requires repayment of interest and principle in equal monthly installments, typically with an interest rate that is fixed for the life of the loan. The percentage of homeowners with traditional home equity loans declined from 5.4 percent in 1988 to 4.9 percent in 1993-94.
Taking up the slack, however, has been the increased use of home equity lines of credit (HELOC). A home equity line of credit is a revolving account that permits borrowing from time to time, at the homeowner's discretion, up to the amount of the credit line. HELOCs also typically have more flexible repayment schedules than a traditional home equity loan and often are based on a variable interest rate pegged to an index such as the prime rate. An estimated 8.3 percent of U.S. homeowners held a home equity line of credit in 1993-94, up from 5.7 percent in 1988.
The principle uses for both types of home equity credit have been to finance home improvements or to repay other debts. Using these loans to purchase vehicles, for educational and medical expenses, and for business uses are also important markets for home equity borrowers, but more so for credit line borrowers than for users of traditional home equity loans.
Other innovative financial instruments have also been developed in the recent past which tap home equity to meet specific needs. For example, "reverse mortgages" or reverse annuities allow a (typically elderly) homeowner to essentially sell their residence back to a financial institution but retain use of it and receive regular payments from the financial institution (usually to cover living expenses and home maintenance costs). The financial institution then has a valid claim on the property which is usually repaid by the borrower's heirs after the homeowner has died and the house is sold.
Interestingly, the payments received from reverse mortgages are considered loan advances and not income. As such, these payments are not subject to federal income tax nor do they affect Social Security or Medicare eligibility.
Although reverse mortgages are not considered second mortgages, they are not available in Texas because this purpose is not one of the enumerated exceptions in the Texas Constitution to the ban on the forced sale of a borrower's homestead.
How Would Increased Home Equity Loan Use Affect The State's Economy?
Allowing more widespread use of home equity loans in Texas would boost the disposable income of Texans because interest payments on such loans are deductible from federal income taxes. In addition, more widespread use of home equity loans would boost the purchasing power of consumers and small businesses because home equity loans typically carry lower interest rates than other types of consumer credit and lower than unsecured credit lines used to fund entrepreneurial activity. This boost would come at the expense of lower profit margins at lending institutions and from tax payments currently made by Texans to the federal government.
Increased use of home equity loans can be expected to displace other forms of consumer credit rather than greatly increase indebtedness. This would occur because the types of individuals that would qualify for home equity loans (typically those with stable and somewhat higher income along with some equity built up in their home) undoubtedly are not now blocked from credit markets. The issue facing this group is one of the price of, not access to, personal loans.
The use of home equity loans as a financing source for small businesses is probably somewhat different. Several studies have observed a positive relationship between business investment and internal cash flow which may relate strongly to imperfections in capital markets. For example, in evaluating new issues of stock, potential shareholders may feel that they have poorer information about the firm's prospects than does the firm's management. These shareholders would therefore be unwilling to purchase the stock without also receiving some "premium" in return, such as a discount from the going price.
From the firm's point of view this type of behavior by potential investors increases the cost of raising capital, especially with respect to other alternatives, such as financing investments from increased cash flow. As a result, internal funds may effectively constrain capital spending if information is asymmetric. This implies that there are some barrier effects to consider in the case of the use of home equity lending for business purposes.
As a result of these considerations, it is reasonable to assume that more widespread availability of home equity loans in Texas would have three distinct economic effects. First, in consumer markets, home equity loans would displace other types of consumer credit. These loans would save consumers interest expenses and be tax deductible, but they would not greatly increase overall indebtedness.
On the business side, greater access to home equity loans to support entrepreneurial activity should generate some new loan activity and some additional indebtedness because access to capital sources is a constraint to business borrowing. Also, to the extent that businesses use home equity loans to displace higher-cost unsecured loans, small business would gain from lower interest costs.
Texas' Untapped Home Equity Market
The total value of savings to consumers and businesses in the state depends on the volume of home equity loans that would be generated within the state should expanded use of this financing source become possible. To estimate this volume, it is assumed that Texas would generate home equity loans in rough proportion to the amount of net homestead equity contained in the state--4.2 percent from Table 1. But, 4.2 percent of what?
As previously mentioned the total national market for home equity loans in 1993 was $255 billion, split between traditional home equity loans ($145 billion) and HELOCs ($110 billion). Because these national figures reflect the current situation in which Texans can only participate to a limited degree in home equity lending, a change in Texas lending would certainly affect national totals.
First, since Texans cannot now access HELOCs under any circumstances, it is assumed that the $110 billion national figure underestimates the "true" national market by 4.2 percent, indicating a potential market of $114.8 billion, of which Texas could be assumed to account for 4.2 percent or $4.8 billion.
On the other hand, traditional home equity lending for the purposes of home improvement is allowed in Texas. From national surveys it is estimated that 38 percent of traditional home equity loans are used for home improvement. This implies that the "untapped" portion of traditional home equity lending in the state could amount to 2.6 percent of the national market for these types of home equity loans (38 percent less than 4.2 percent). This implies that the national total of $145 billion underestimates the national potential market for these loans by 2.6 percent, indicating a total size of $148.8 billion, of which Texas would account for 2.6 percent, or $3.8 billion.
Accordingly, the total potential untapped home equity loan market in Texas is an estimated $8.6 billion. Finally, assuming that Texas uses of these loans would parallel national trends, 18 percent or $1.5 billion of this potential would be used for business purposes while the remaining $7.1 billion would be used by consumers.
How would opening access to home equity loans affect consumer credit? Several variables are involved, but some estimates are possible. Table 2 compares the annual interest costs of various types of consumer credit loans based on an initial loan value of $30,000 and a four-year pay back period. This amount was chosen because, over the life of the loan, the average outstanding loan value (in column five) is about equal to the national average value of the outstanding balance on home equity loans.
As is detailed in this table, tax-deductible home equity loans present real savings over other forms of consumer credit, even in instances in which the home equity loan carries a higher interest rate. For example, based on rates prevailing in January 1996, a consumer could save nearly $230 annually by financing a $30,000 educational loan as a home equity loan, even though the professional education loan carries an interest rate of 7.43 percent, lower than the 8.25 percent rate available on home equity loans. Clearly, all of these savings come from reduced federal income tax payments.
This benefit increases as other, more costly types of consumer credit are compared to home equity loans. Annual savings on car loans are, in this example $383. The consumer can reap more than $1,160 annually by using home equity loans rather than unsecured personal loans, and more than $1,600 annually over financing on credit card debts.
On a statewide basis, the net savings attributable to the use of home equity loans for non-home improvement purposes would depend on the "mix" of loans that were displaced, the number of loans generated and the degree to which taxpayers itemized deductions on federal income tax returns.
Indicated in Table 2 is the distribution of the various types of consumer debt in 1992. This mix of debt can be used to estimate a weighted average interest rate on non-home equity consumer loans which, using rates in effect in January 1996, is 11.36 percent.
The average monthly interest cost of a 4- year home equity loan at an annual interest rate of 8.25 percent is $106.73. In contrast the same loan with an annual interest rate of 11.36 percent requires an average monthly interest payment of $147.57, or an additional $40.84 a month. Based on an average outstanding balance of $15,478.56 over the life of the lower cost home equity loan, the total $7.1 billion in expected consumer loans indicates a total of 458,700 such loans would be generated statewide. On an annualized basis this amounts to an interest cost savings of $224.8 million.
Assuming that the average Texan using a home equity loan pays a marginal federal income tax rate of 28 percent, the "true" interest cost of the home equity loan is actually $76.85 monthly or an additional savings of $29.88 monthly. On the basis of 458,700 loans, tax deductibility of these interest costs could yield tax savings of $164.4 million annually if all Texas taxpayers itemized deductions. However, based on the profile of federal taxpayers in Texas who would likely utilize home equity loans, it is expected that only about 60 percent would take advantage of this tax savings, indicating a statewide savings of $98.7 million.
In total, the average home owner in Texas that currently itemizes deductions on their federal income tax could save as much as $849 annually by substituting the average home equity loan for existing consumer credit.
Home Equity Loan Advantage over Other Consumer Credit AlternativesDeductible from Average Annual Average Annual Home Federal After Tax Outstanding Equity Loan 1992 Distribution Interest Loan Type: Interest Income Payments* Loan Value* Advantage of Consumer Debt Rate (1) Tax? (2) Home Equity 8.25% yes $922.18 $15,478.56 --- Professional Education Loan 7.43% no $1,152.15 $15,402.90 $229.96 2.1% New Car Loan, Bank 8.41% no $1,305.94 $15,492.25 $383.76 5.7% Personal Loan, Bank 13.33% no $2,082.82 $15,933.10 $1,160.64 2.7% Credit Card 16.25% no $2,546.86 $16,183.55 $1,624.68 4.0% Weighted Average Interest Rate, non-home Equity Loans (3) 11.36% no $1,781.00 $15,760.00 $859.00 * $30,000 initial loan value repaid over four years, marginal tax rate of 28 percent.Sources: (1) Financenter, Inc., a privately-held Arizona corporation providing on-line access to the services of national financial companies. Data current as of January, 1996. (2) Derived from Arthur B. Kenneckell and Martha Starr-McCluer, "Changes in Family Finances from 1989 to 1992, Evidence from the Survey of Consumer Finances," Federal Reserve Bulletin, October 1994. Table 11 lists 5.7 percent of all family debt as due to vehicles, 2.1 percent as attributable to education loans, 4.0 percent for goods and services (assumed by Kenneckell and Starr-McCluer to represent credit card debt) and other unclassifiable loans accounting for 2.7 percent. (3) Weighted average of annual loan costs with weights based on 1992 distribution of consumer debt.
From national surveys of the usage of home equity loans, about 25 percent of the respondents cited the ease of obtaining a home equity loan as the prime attraction of these loans. One interpretation of this response is that for this group of users, the availability of home equity loans significantly lowered the barriers to credit. This gives a reasonable approximation to the possible size of the new business loan activity the could be expected from expanded use of home equity lending. It is estimated that $375 million in new business loan activity could be expected to result from expanded access to home equity lending. This infusion of capital and any resulting economic activity could be expected to be a one-time occurrence.
The remaining 75 percent of the estimated $1.5 billion in business loan activity would benefit from lower interest costs. From Table 2, unsecured personal loans, a primary avenue for small business loans outside of home equity lending, carried an annual interest rate of 13.33 percent. Again considering a $30,000 4-year loan, this implies an average monthly interest payment of $173.57, or $66.84 more than the average monthly interest payment on the same sized home equity loan.
In turn, this implies that the $1.125 billion in business loans that could be replaced by home equity loans would generate annual interest cost savings of $58.3 million.
Previous Attempts to Allow Home Equity Lending
During the 1980s and 1990s, repeated legislative attempts have been made to broaden home equity lending in Texas. The form these attempts have taken are instructive in pointing out the issues and problems surrounding extending the use of home equity lending beyond its current constitutionally limited areas.
It appeared briefly in 1994, that this whole issue was moot when the U.S. Circuit Court of Appeals ruled that federal banking statutes and regulations preempted the Texas homestead law. The U.S. Supreme Court let the ruling stand in October 1994, but Congress later approved an interstate banking bill that superseded the court ruling.
In 1994 and 1995, the Texas Senate Interim Committee on Home Equity Lending proposed changes to the Texas Constitution. First, over concern that completely eliminating the consumer protection afforded in the constitution would not be appropriate, instead of simply repealing the homestead protection, it was proposed to extend the cases for which a forced sale would be allowed to include "equity loans," limited to home equity loans, second mortgages and reverse annuity mortgages.
To diffuse criticism that equity loans could cause massive defaults during recessions or that unduly burdening property with debt would cause a slow-down in real estate turnover, the committee proposed capping the total amount of equity that could be pledged in support of loans to 90 percent of the home's fair market value. Lower percentages were discussed, but not adopted.
To answer the concerns of consumer groups that bankers or other lenders could put undue pressure on borrowers, particularly on seniors, the implementing legislation included a 15-day cooling-off period after requesting a loan and a three-day period after the signing of the loan papers during which the borrower could withdraw the application. Moreover, loan documents could only be signed at the office of the lender, a title company or an attorney, and not at the borrower's home.
To address the concerns of rural residents that lenders could begin requiring them to use home equity loans to secure other loans, such as those for planting crops or operating ranches, conditions were included prohibiting a lender from requiring a homestead as collateral on any other form of loan or requiring a borrower to use an equity loan to repay another loan.
There were also some special provisions on the use of reverse mortgages to provide additional consumer protection. Other restrictions that were considered would have prohibited equity loans on agricultural homesteads, limited the use of loans to medical or educational expenses, and, except for reverse mortgages, prohibited issuing a home equity loan to anyone over 65.
Total Texas Impacts
In total, the interest cost and tax savings to Texas consumers from wider access to home equity loans could reach $323.5 million annually once the advantages of these new types of loans became widely known in the marketplace. In addition, the interest cost savings to small businesses in the state would raise this annual total impact to an estimated $381.8 million. The $375 million in new small business borrowing estimated to result from wider access to home equity loans would be a one-time infusion of new business spending into the state's economy.
1 Last November, Texas voters approved expanding the allowable uses of home equity lending in Texas. Proposition 4, which passed with 51.4 percent of the vote, allows individuals to use the accumulated, R. Glenn Hubbard and Bruce C. Petersen, "Financing Constraints and Corporate Investment," Brookings Papers on Economic Activity 1, 1989, pp 141-195.
2 U.S. Department of Commerce, American Housing Survey for the Houston Metropolitan Area in 1991, Current Housing Reports H170/91-49 (U.S. Government Printing Office, Washington, D.C.), Table 3-15.
3 Glenn B. Canner, Charles A. Luckett and Thomas A. Durkin, "Home Equity Lending: Evidence from Recent Surveys," Federal Reserve Bulletin, July 1994, pp. 571 - 583.
4 See, for example Steven M. Fazzariconsumer itemizing federal tax deductions and a marginal tax rate of 28 percent.
5 It is assumed that interest expenses on unsecured credit sources currently used for business purposes are now tax deductable as a business expense.
6 All of these savings are based on the equity in their home to secure a loan to pay off a lien filed by a spouse on the property following a divorce settlement or for payment of a federal tax lien against a homestead.
7 Much of this discussion is drawn from Texas House of Representatives, House Research Organization, "Should Texas Allow Home Equity Lending?," February 27, 1995.