Home Equity: Fixed vs. Floating
By: Jeff Brown

Take a look at the current BankingMyWay rates survey, and you’ll see something odd: during the past week, all the mortgage rates have gone down and all the home equity rates have gone up. And those home equity rates are a lot higher, all more than 8% or 9%, while the highest mortgage rate, for the 30-year fixed-rate loan, averages about 5.2%.

Why are home equity rates so much higher when both loans use the home as collateral?

Mainly because the home equity lender stands in line behind the mortgage lender, making it riskier to issue home equity loans. If the homeowner defaults, the mortgage lender forecloses on the property to recover the outstanding debt. The home equity lender recovers what it is owed only if there’s something left over. These days, many homes are worth less than the mortgage balance, so the home equity lender may get nothing.

Despite rates of more than 8%, home equity installment loans, which charge a fixed rate for the loan’s life, can be a good way to pay for a renovation or college education. Most investors can deduct home-equity interest payments on their federal taxes. So an 8% loan costs just 6% after taxes, assuming a 25% tax bracket.

That’s a lot better than paying 18% on a credit card, especially as card interest is not tax deductible.

But there’s another option: the home equity line of credit, or HELOC. The HELOC search tool uncovers many charging just more than 4%. Some credit unions charge less than 3%.

The reason: HELOCs are floating-rate loans that typically adjust every month or so. The lender can charge less because it knows it can always charge enough to make a profit even if prevailing interest rates rise. Lenders making home-equity installment loans must charge more because their fixed rate must be high enough to offset the risk of prevailing rates rising before the loan is paid off.

HELOCs are “revolving-credit” loans, which means they provide a borrowing limit. Below that limit you borrow only what you want to, just as you do with a credit card. Home equity installment loans usually come in a lump sum, like a mortgage or car loan.

Most HELOCs adjust by adding a “margin” to an underlying index, typically the prime rate. With prime now at 3.25%, a HELOC with a standard two-point margin would adjust to 5.25% after the initial, low “teaser” rate expires.

Of course, there’s a risk the rate could go higher sometime later. So borrowers are wise to follow a simple rule: high-rate loans for short-term needs, low-rate loans for long-term needs.

If you’re going to be paying interest for years and years, it’s best to lock into the lowest fixed rate you can get. At just more than 5%, the standard 30-year fixed-rate mortgage is the best choice for most homeowners. An adjustable-rate mortgage could start out lower but might charge much more in the future.

High-rate loans, like credit cards, should be used only if you plan to pay off the balance very quickly, else interest rates dramatically increase the cost of your purchase. Ideally, you should plan to pay the whole card bill during the grace period, so there will be no interest charge at all.

The home-equity installment loan would be a good choice for an expensive need that would have to be paid off over time, such as a big home improvement or a child’s education. At the start, you’d pay more than a HELOC would charge, but the HELOC could go higher someday.

The HELOC is best for modest purchases, or to borrow money that will be paid off fairly quickly. It’s just too risky to have a big loan balance if your payment might rise by 50% or 100%.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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