|
It's time to consider whether to keep your home equity line of credit or get rid of it.
Rates on credit lines have been rising for a year and a half. Meanwhile, long-term mortgage rates have been falling for a month and a half. This up-down combination gives borrowers a chance to pay off their credit lines with other types of loans.
To decide whether it makes sense to ditch your credit line, you have to do some math and think about the price you're willing to pay for the flexibility of having a credit line.
If the math in this article makes your head hurt, you can ask a mortgage broker or loan officer to crunch the numbers.
Home equity lines of credit, known to mortgage geeks as HELOCs, usually go up and down with the prime rate. Credit lines were a great deal for borrowers from June 2003 to June 2004 because the prime rate was 4 percent during that time. A lot of homeowners got HELOCs at prime or close to it. Credit lines remained attractive even after the prime rate began its slow rise in the middle of 2004 because the rates still were relatively low -- for a while.
Pendulum swings
The pendulum has swung by 3 percentage points, which is a lot when you're talking about large debts. In September 2003, the average rate on a credit line was 2.08 percentage points lower than the rate on a 30-year, fixed-rate mortgage. At the end of 2005, the rate on the credit line was almost 1 percentage point higher.
If you have a credit line, the rate almost surely is higher than the rate on your primary mortgage. Some borrowers might want to keep their credit lines anyway. Others might benefit from doing what's called a "cash-out" refinance of their primary mortgage -- borrowing more than the outstanding balance on the primary mortgage and using the proceeds to pay off the credit line. Still others might want to swap their credit line for another type of equity debt.
"What I do for people is I look at the weighted average of what their mortgage rate is," says Bob Moulton, president of Long Island-based Americana Mortgage Group. Moulton offers the following example (here comes the math):
How to -- oof! -- weigh your debt
Let's say you have a $200,000 primary mortgage at a rate of 5.875 percent, plus a credit line with an outstanding balance of $100,000 at 7.25 percent. The first thing to do is add all of the mortgage debt. In this case, it's $300,000.
Then you divide the amount of the primary mortgage ($200,000) by the total debt ($300,000). The result is 0.67. Multiply that by the rate on the primary mortgage: 0.67 times 5.875 equals 3.94.
Do the same with the credit line. The outstanding amount on the credit line is $100,000. Divide that by $300,000 and you get 0.33. Multiply that by the credit line's rate: 0.33 times 7.25 equals 2.39.
Add those two numbers to get the blended average: 3.94 plus 2.39 equals 6.33. In this example, the hypothetical homeowner is paying a blended average of 6.33 percent on both mortgages.
What can you do with a blended average?
In this case, Moulton says he would tell the borrowers that they could do a cash-out refinance and eliminate the risk of the HELOC rate going up even more.
In the first week of 2006, a borrower with good credit might be able to get a 30-year fixed at 6.25 percent, which is lower than the blended average in this example. Or the customer could get a 5/1 ARM with an introductory rate of 5.75 or 5.875 percent. The latter option would be a good choice for someone who plans to sell the house within five years, because a 5/1 ARM's initial rate lasts five years, then adjusts annually after that.
There are a lot of things to consider here. If you keep a low balance on the credit line, it doesn't cost you much every month, and you might as well keep it so you can borrow against it in an emergency. If you periodically draw against the credit line (to pay college tuition, say), and pay down most or all of the balance before using it again, it makes sense to keep it.
And if you plan to sell your house within the next three years or so, a cash-out refi would be a money-loser because the closing costs would outweigh the short-term monthly savings.
But let's say you plan to stay in the house for five or more years and you keep a balance of many thousands of dollars on your credit line, in that case, consider doing a cash-out refi or other options.
Other options
What other options? You could pay off the HELOC with a fixed-rate home equity loan. The equity loan's rate will be higher, but it won't change. The prime rate, on the other hand, is expected to rise to 7.5 percent or 7.75 percent early this year.
Another option is to get a hybrid HELOC. Wells Fargo is the only nationwide bank to offer such a loan, which it calls the SmartFit Home Equity Account. It has some features of a fixed-rate home equity loan and some features of a variable-rate equity line of credit.
SmartFit is a line of credit that you can draw from over and over again. When you draw from it, the interest rate on that sum is fixed for three, five or seven years, depending on what you choose. During that time, you can pay only interest or interest plus principal. At the end of the fixed period, the rate on that portion of the balance moves up and down with the prime rate, or you can convert it into a fixed-rate advance.
The SmartFit account seems tailor-made for people who have lines of credit with competing banks and who are worried that rates will continue to rise. The starting interest rate depends on a number of factors; right now in California, it starts at 7.5 percent and goes up.
It's also a good deal for people who don't want to pay 30 years of interest on the things they buy with their lines of credit, says Doreen Woo Ho, president of Wells Fargo's consumer credit group.
Pay off sooner
Customers usually have a purpose for their credit lines, such as buying cars or renovating their homes, Woo Ho says, "and many customers see it as something that they want to pay off sooner."
When you roll a HELOC balance into a cash-out refinance of the primary mortgage, you end up paying interest on your HELOC purchases for the life of the new loan, which usually is 30 years. Keeping that balance separate, in its own equity loan or line of credit, encourages you to pay for those purchases quicker. You pay less interest in the long run.
|