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Last spring I discussed how many clients were utilizing home equity lines of credit, HELOCS in industry jargon, to finance their home improvement projects. These loans are extremely versatile in that borrowers are able to tap into accumulated equity that they have acquired in their home and set up a line of credit that can be borrowed against and paid down over a certain period. For the first ten years of the loan, known as the draw period, the line of credit works exactly like a credit card: a minimum payment due each month, interest paid only on the balance that is in use, no re-qualification process whenever money is needed – there are no questions asked as to what the money is used for. These loans are also a good choice to consolidate other debts because the interest paid is tax deductible. Furthermore, most of these HELOCS have no closing costs when they close. Borrowers with strong credit profiles qualify for a home equity line of credit with an interest rate of “prime for life.” What does that mean? Well, these lines of credit are based on the prime interest rate. Last year at this time the prime interest rate was 4%. That is a pretty darned good rate considering there are no closing costs involved. Many found this type of loan last year to be a no-brainer. Well, times have changed. While these loans still make a lot of sense for a lot of people and the no closing cost option is particularly attractive, their downside has been on display over the last 12 months. That downside is that the interest rate on these lines of credit is not fixed. Instead the rate will mirror changes by the Federal Reserve Board. Consequently, borrowers enjoying the rate of 4% exactly one year ago are now dismayed to see that their interest rate is currently 6% (current 30 year fixed rate loans are at 5.75%). For homeowners who took out these types of loans 3 years ago, this past year’s rate spike has been particularly difficult to stomach because the prime rate was relatively stable until this past year when the economy began to strengthen. These borrowers have been spoiled and are only now facing the negative aspects of an adjustable rate loan. Now the rate is volatile – many predict the prime rate to continue to jump in .25% increments. When faced with a client who needs to borrow against home equity, it is extremely important to know how long this person plans to stay in the house. In fact, this bit of knowledge is fundamental to making other decisions during the loan process (whether or not to pay points, for instance). As a general rule, if the owner plans on selling the house in 3 years, then a home equity line of credit makes more sense because there is no financial commitment up front i.e. no closing costs. On the other hand, it is much easier to justify paying closing costs when an owner is sure to be in the house long term. In this instance, a “cash-out refinance” will pay off the existing loan with a new loan (adjustable or fixed) at a higher dollar amount. Closing costs are taken from the equity (so the client does not need to open a check book at the closing table) and the borrower walks away from the closing with a lump sum. As
always, neither option is inherently better or worse than the other.
What dictate the appropriateness of the loan is the borrower’s
goals and preferences. |
