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Amid the low-mortgage-rate frenzy prevailing since 2001, home equity products have been the forgotten ones, with attention lavishly devoted to mortgage products. But we are on the cusp of a change. Home equity loans and lines of credit are sure to gain greater favor among homeowners as the mortgage refinancing boom subsides.
The combination over the last few years of low mortgage rates and steady appreciation of real estate prices has given homeowners a newfound source of capital -- the ever-growing share of home equity they possess. Homeowners have stampeded to mortgage lenders to refinance their existing mortgages and extract additional cash from the equity. The uses have varied from home improvements or debt consolidation, to the purchase of big-ticket items such as automobiles or vacations. Some even took the money and ran to the stock market. Retirees have increasingly turned to reverse mortgages to unlock this accumulated equity and provide additional retirement income that is sorely needed in this era of decades-low interest rates.
Low rates and the tax deductibility of interest heighten the appeal to homeowners seeking to tap into their accumulated home equity. When the great refinancing ride slows, home equity products will be the new vehicle of choice for homeowners eager to get their hands on this equity.
Those who venture into the realm of home equity products will face the dilemma of taking out a fixed-rate home equity loan or a variable-rate home equity line of credit, also called a HELOC. Rates on HELOCs can be found for about 4.75 percent now, and perhaps lower if an introductory rate is being offered. But this 4.75 percent could be 7.75 percent a few years down the road, perhaps once a hearty balance has been tallied.
Might the borrower be better off, from a budget standpoint as much as an interest-cost standpoint, by opting for a fixed-rate loan with a higher rate but a monthly payment that is set in stone? It depends. HELOCs clearly get the edge for home improvement projects that incur debt in stages, as you borrow only what you need, when you need it.
But what about a debt consolidation, where other obligations are piled into one loan all at once? Although the low interest rates of today will inevitably begin to climb, the forecast for when remains cloudy. Continued economic sluggishness means the Federal Reserve will keep interest rates low for a longer period. Given the prevailing low-rate environment and the likelihood that it may take quite a while before today's low HELOC rate rises to equal or exceed the rate currently available on a fixed-rate home equity loan, the HELOC remains the more inviting alternative. For those borrowers with the discipline to pay down, rather than tack on, debt now while rates are low, they will clearly come out ahead with the lower-rate HELOC.
However, if the temptation of an open line of credit, an attractive interest rate, and a tax deduction are more than can be resisted, opt instead for the home equity loan despite the higher rate throughout the loan term. The lower initial rate on a HELOC won't do any good if the debt load ends up larger instead of smaller several years hence.
Using home equity for a one-time, large-scale purchase mandates the same thought process. Shorter payback periods are more conducive to the variable-rate HELOC, as the debt will be repaid before rates have sharply increased. A longer repayment period lends itself to the fixed-rate and monthly payment of the home equity loan. Regardless of the intended use, shop both products, and consider which is more advantageous to your circumstances. Evaluate both the after-tax interest cost and the ability and timetable for ultimately retiring the debt.
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