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As homeowners struggle to keep afloat financially, the federal government has been making some highly publicized moves in the guise of helping homeowners avoid foreclosure. Everything from the stimulus checks intended to help fuel consumer spending to the Federal Reserve’s multiple interest rate cuts and now the Housing and Economic Act of 2008. These are all well-intentioned moves to help stabilize an uncertain economy. Couple the high foreclosure rate with mounting personal debts and it is little wonder that the government will again tinker with the economy.

Tax Reform Act of 1986
Many have called for Congress to repeal or at least address the Tax Reform Act of 1986. In 1986, the government had been worried about increased levels of consumer spending coupled with a decrease in savings. Consumers had been using credit cards for large purchases and interest rates had risen to an average of 18.26 for the year.

Alarmed at this steady increase in interest rates, Congress moved to slow consumer spending by eliminating the tax deduction for interest paid on credit cards. Since the Tax Reform Act of 1986, credit card interest rates have dropped to an average of 14.68 for 2007. While spending did slow temporarily, people wanted to continue living the lifestyle to which they were accustomed. This resulted in people looking for and finding loopholes in the new tax act. Home equity represented the largest piece of household wealth in the U.S. With an increase in the use of home equity through refinancing, second mortgages and home equity lines of credit (HELOC), the American homeowner now had a tax-deductible way to continue fueling consumer spending. This is the growth of utilization of traditionally non-liquid assets for liquid purposes. When reinvested into a property through expansion or renovation, then the partial use of a home’s equity to increase that same home’s equity makes sense.

Tapping into home equity
As homeowners began to see record appreciation in their home’s appraised value, many homeowners began to visit that equity ATM more often, for larger amounts and for reasons other than capital improvements on the property. At the same time home equity credit was being tapped, consumers had disregarded the fact that credit card interest was no longer tax deductible and used credit cards to fuel their consumer spending. The gains that had been achieved by the Tax Reform Act of 1986 in reducing credit card rates and increasing savings began to be reversed. As a result, historically low mortgage interest rates that had the advantage of being tax deductible began to ignite the wildfire of mortgage products.

Many homeowners became aware of what they were paying in non-tax deductible credit card interest and the historically low tax deductible mortgage interest rates and were powerless to resist the promise of saved money. Many borrowers that had become financially strapped because of irresponsible spending and were being hounded daily by credit card companies, readily agreed to the promised relief that could come through refinancing their debt. This could have worked out OK for most homeowners if they borrowed just what they needed at favorable terms. For many, however, they fell into the new subprime market because of their inability to pay their consumer credit card debt.

Finding a better solution
So now we find ourselves with near-historic foreclosure rates in many parts of the country. People are hurting and crying out for solutions to the mess. Where do we look for answers? The government of course. The same government that attempted to slow consumer spending with the Tax Reform Act of 1986 now brings the American homeowner the Housing and Economic Recovery Act of 2008. In this new act, the government eliminated down-payment assistance, agreed to help homeowners through the use of government-insured Federal Housing Administration (FHA) loans on the condition that mortgage holders write down the principal of the mortgage and borrowers agree to share future equity with the government and the borrower can afford to repay the new loan.

The 1986 act, with the known or unknown acquiescence of homeowners, helped to wreak the havoc we see today. Couple that act with this new one and you actually have a powerful tool to reign in consumer spending while simultaneously helping many homeowners to avoid foreclosure. Consumers will still have the choice to refinance, but the government will now hold an equity interest in the traditionally largest piece of household wealth. But there is little alternative for most financially distressed homeowners. Most lenders are now awaiting guidance from the FHA, which we anticipate will be issued in a Mortgage Letter by Steve Preston, the Secretary of Housing and Urban Development.

Rich Dansereau, Mortgage Expert