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Jan. 27, 2000 -- For home equity line of credit borrowers, prime doesn't look so prime anymore.
Those who thought they would get cheap money forever because the Wall Street Journal prime rate was at 7.75 percent last year have taken some bitter medicine since then. The benchmark for rates on 85 percent of outstanding HELOCs has already climbed 75 basis points to 8.50 percent. More foul-smelling ichor, in the form of rate hikes by Alan Greenspan and the Federal Reserve Board, will likely hit by midyear, too.
Carefully consider your options
Homeowners do have some ways to fight back and lower their HELOC costs. But people should think carefully about whether and how much they need to borrow. After all, each tick higher for interest rates makes it that much tougher to come up with the monthly loan payment.
"When mortgage rates broke 8 percent, to me, that was a benchmark. I think that's a danger zone," says Bill Slater, manager of the Phoenix Neighborworks Homeownership Center in Arizona. "We're in a climate where Greenspan has kind of hinted that he thinks it's not tight enough and we probably ought to be raising rates to slow things down a bit."
"The first thing that leaps to mind to mitigate the rising rate climate is to stop spending," he adds. "Revisit your budget. Revisit your money-management skills. Sit down and have a talk with your family."
That's always been important, but it's especially so today with interest rates behaving the way they are. Every time the Fed raises rates, banks increase their prime rates by an equivalent amount within hours and their equity rates within a few weeks. The average HELOC rate now hovers around 8.71 percent, up from 7.98 percent last March, because the Fed pushed through three 25-basis-point hikes in 1999.
Future doesn't look much brighter
Unfortunately, things don't look much better this year. Economists expect either a 25 basis point or 50 basis point increase at the agency's next policy-setting meeting Feb. 1 and Feb. 2. Another 25 basis points will likely follow March 21. All told, these moves will push HELOC rates to near double-digit levels.
How significant an impact will this have on a family's finances? Consider that the average consumer with a home equity line had a balance of $26,600 last year, according to a recent Consumer Bankers Association study. At a rate of 7.75 percent, a borrower could end up paying $5,626 in interest. That's assuming the payment started at 2 percent of the balance and remained constant.
Raise the rate to 8.5 percent, though, and the price tag climbs to $6,353. At 9 percent, it's up to $6,863 -- $1,200 more over the five years and three months it would take to retire the debt. If rates rose during the loan term, or if the borrower made additional draws and allowed the payment to slip as the balance shrank, the cost would be even greater.
"Smart borrowing is always the key word," says John Barton, vice president for home equity lending at Chase Manhattan Corp. of New York. "Consumers want to make sure that they can handle the debt they're bringing on and do it in a way that doesn't put them in a situation where they'll find themselves falling behind."
There are ways to save
Those who survive the gut-check process do have ways to save money. Holders of existing lines can agree to make their payments electronically, for example. Many banks will drop a borrower's rate by 25 basis points or 50 basis points if the payment is debited from a checking account at the same institution. New shoppers can get discounts, such as waived checking account fees or lower rates, from some banks if they agree to consolidate all of their business there, too.
Other insider tricks can have an even greater impact. Consider that most lenders charge tiered rates based on a borrower's combined loan to value, or CLTV, ratio. The ratio measures the amount of debt someone would have if a home equity line was tacked on top of the first mortgage. By borrowing a couple of hundred or thousand dollars less, someone can lower the CLTV ratio enough to cut interest costs considerably.
Say somebody with a $150,000 home still owed $100,000 on a first mortgage. The borrower's basic loan to value ratio would be 67 percent. Adding a line for $20,000 would raise the CLTV to 80 percent, while including a line for $30,000 would raise it to 87 percent.
At Citizens Financial Group Inc., a checking accountholder could get the smaller line at prime minus 25 basis points, or 8.25 percent, according to Mary Leach, director of retail lending services. But a customer who tried to borrow the full $30,000 would fall into the Providence, R.I.-based bank's higher rate tier. The interest rate there is prime plus 300 basis points -- a sizable 11.5 percent in late January.
More cost-cutting strategies
Besides borrowing less, more experienced borrowers can use several other strategies to cut their costs. Some will be able to find lenders who charge no closing costs and offer teaser rates. A borrower could hop from teaser rate to teaser rate in that case, enjoying 4.9 percent for six months at one lender, then 5.99 percent at another. Be sure to check the loan agreement, though, because many companies make customers reimburse them if they close their lines before a certain amount of time passes.
Other consumers may be able to use home price appreciation to their advantage. Somebody who had to borrow at the high-CLTV rate a few years ago, for instance, can refinance into a new lower-ratio line to cut the rate.
Borrowers who want to put an end to rate-related worries altogether can fix the rate and payment schedule on their outstanding balances, too. Somebody could refinance the HELOC into a fixed-rate home equity loan, or combine the HELOC and first mortgage into a larger first mortgage. About a third of U.S. banks offer what's called a fixed-rate option, too. It allows a consumer to take a variable-rate HELOC balance and fix the rate and payment that applies to it, though fees and restrictions usually apply.
"If they have a $100,000 home equity line, they can lock it into a fixed rate," says Tom Black, director of secondary markets at MortgageIT, a New York-based online mortgage broker. "You're locked in and it will guarantee your loan will be paid off in 10 to 15 years."
Higher rates increase equity risk
While these steps can help lessen the impact of rate increases, they can't eliminate it. Experts caution that the higher interest rates go, the riskier home equity lines get. Families with short-term adjustable rate mortgages and home equity lines are in particular danger because they'll face payment hikes on both loans if current interest rate trends persist. They should work toward paying off as much of their debt as possible before it's too late.
"In any rising interest rate market, you need to be concerned about any short-term adjustable rate mortgage, or anything that's tied directly to the market," says Black. "Most home equities are tied to prime and we may see a half of a point increase to a full point increase."
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