In my last article I detailed the fact that the rates on home equity lines of credit (HELOC’s) have been moving steadily upwards in .25% increments with each meeting of the Federal Reserve Board. Many people who have these loans grew to love them during the long period of their interest rates holding steady at 4%, the prime interest rate. However, as a result of the rate hikes, the interest rates on these loan products have climbed 2.25 points in the past year to sit currently at 6.25%. That is quite a climb and sits in stark contrast to the rates of fixed rate loans and hybrid adjustable rate loans (ARM’s) which, despite endless warnings of a steady upswing, can still be locked in under 6%. Not only does the HELOC’s continual climb in interest rates affect the decision making process of current homeowners in need of home improvement financing, it also can have a significant impact on how a new home buyer chooses to structure the mortgage loan on that purchase. Consider the following example of a borrower who closed recently on a purchase. My client was using the proceeds from the sale of his previous home to put towards the down payment of his new house. The purchase price on the new house was $348,500 and he put $60,000 towards a down payment. That $60,000 represented 17% of the value of the house. Because he was putting less than 20% down, he was going to have to pay private mortgage insurance (PMI) to the lender. One common way of avoiding the PMI requirement is to split the amount being financed into two loans, one representing 80% of the home’s value and the second smaller loan “piggybacking” on the first to make up the difference. Typically, the second smaller loan is a HELOC. Such an arrangement is what my client asked for. When
I looked at the numbers and all of the factors involved, I advised
my client to reconsider. Why? Shouldn’t the borrower avoid
paying PMI whenever possible? That is the standard logic but it
would not make sense in this case. First of all, because the client’s
down payment was so close to the 20% threshold, the monthly PMI
was only $77 and would disappear completely once my borrower gained
3% more in equity, either by eating into the principle through regular
payments or by the home appreciating in value. If we structured
a piggyback arrangement, the second HELOC loan would be so small
that the lender would add on a sizeable 3% margin to make it worth
their while, thereby increasing the already volatile HELOC rate
even more. If the rates on the HELOC remained steady, which is unlikely,
the payment on that loan would be $74. So, by utilizing a HELOC
loan as the smaller second loan, my client would have saved himself
$3 a month to begin with. When the rates on the HELOC jump another
.25% at the next meeting of the Federal Reserve Board, my client’s
monthly payment would then be even more than the monthly PMI. |
