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For home equity lines of credit (HELOCs), most banks set their rates based on the shortest-term market rate of all, the Wall Street Journal prime rate. It moves in lock step with the fed funds rate.
The Fed is currently in a rate-rising mode. This is pushing rates on home equity lines of credit higher for both new and existing borrowers, as HELOCs carry variable interest rates.
But equity loans and lines of credit usually come without closing costs, so they can be $2,000 or $3,000 cheaper than a mortgage refinance.
"It is relatively rare," said Vickie Hampton, associate professor of family financial planning at Texas Tech University in Lubbock, Texas. "But if you can get as much money as you need with good terms on a home equity loan as you can on a mortgage refinance, and you can get a rate that's attractive and lock it in, then that seems like a very wise thing to do."
The best equity candidates
So who should go for an equity loan or line of credit rather than a cash-out refinance mortgage?
Consumers who plan to pay off their loans in a reasonable amount of time and those who don't need to borrow much money make good candidates. That's because banks offer their lowest rates on shorter-term equity loans.
Long-term equity loans tend to have rates that are higher than fixed-rate mortgages, even when the prime rate is low. And, customers who need $75,000, $100,000 or more will usually find they need loans with longer amortization schedules to keep their payments affordable. Most equity loans amortize over 10 years or 15 years, while many first mortgages amortize over as many as 30 years.
Customers who took out first mortgages during periods of extremely low rates may want to consider equity loans or lines of credit too. It doesn't make sense to refinance into a new first mortgage at a larger balance and higher rate and pay a couple thousand dollars in closing costs to do so.
"If you've got a favorable rate on a first trust deed mortgage, something in the 6s thereabouts or low 7s, you don't want to pay off a $100,000 mortgage to take out $20,000 and raise the rate on the whole amount," said Richard West, senior vice president and division manager at San Francisco-based UnionBanCal Corp. "You're much better off borrowing $20,000 and keeping the first mortgage.
"Each individual has to do the math and decide which way to go."
Customers willing to bet the economy will remain weak for a while may want to look first at equity lines of credit. If the Fed doesn't raise rates for a long time, the prime rate will stay low as well.
That's what happened between December 1991 and May 1994, when the prime rate remained below 7 percent and bottomed for many months at 6 percent. Someone who borrowed via a 30-year mortgage refinance at the beginning of that time period, by comparison, would have been stuck with an 8.25 percent interest rate.
Line of credit flexibility
But even if that doesn't happen, lines of credit offer more flexibility than first mortgage refinances. Equity line borrowers only pay interest on what they borrow. If rates look like they're going to rise in a few months, they can pay off what they owe, then not carry a balance until the prime rate and the rates on their lines come back down.
Cash-out refinance customers get all their money up front and have to pay interest on the entire balances of their loans until they're paid off.
"The HELOC gives them a lot more flexibility," said Vijay Lala, executive vice president for product development and support at Calabasas, Calif.-based Countrywide Credit Industries, Inc. "It gives them what amounts to a flexible mortgage."
Watch for additional costs
When borrowing with equity loans or lines of credit, borrowers should watch out for additional closing costs some lenders charge when those loans are in the first-lien position.
Banks agree to waive costs on equity loans and lines of credit because they don't have to perform many of the same closing and underwriting steps required on first mortgages. Many opt for computerized property valuations rather than full appraisals, for instance, and order title searches, but not new title insurance.
But when someone owns a house free and clear, there aren't any recent mortgage documents and safety checks to fall back on. So, some lenders go through the same steps they undertake on first mortgages and stick customers with the bill.
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