Is This a Good Time For an HEL?

7 June 2004

"I have a first mortgage for 161K at 7.125%, a second for 40K at 7.5%, and 50K of credit card debt at 13-19%. We could refinance the first and second mortgages into a fixed-rate loan at 6.25%. But we could also refinance them into a home equity loan at 4% (prime rate plus zero) and no cost, and with interest- only payments for 10 years. The sharp reduction in mortgage payments would allow us, at long last, to pay down our credit card debt rapidly. It seems like a dream come true. What am I overlooking?"

You are overlooking the risk of a sharp increase in the prime rate, which could quickly turn your dream into a nightmare. Some borrowers are positioned to take this risk, but you aren’t one of them.

In recent weeks I have been deluged with questions about refinancing into a home equity loan (HEL). Traditionally viewed as a second mortgage placed atop a first mortgage, the new game in town is to replace the first mortgage (and an existing second mortgage if there is one) with an HEL first mortgage.

This has been driven at least partly by recent interest rate changes. Rates on 30-year fixed-rate mortgages in early June, 2004 were about 1% higher than they were one year earlier, but the prime rate hadn’t budged. This gave HELs, which are priced at the prime rate plus a margin, the appearance of a bargain. Furthermore, in many cases including yours, HEL transaction costs are very low or zero. That’s the good news.

The bad news is that HELs are really adjustable rate mortgages (ARMs) without the protections that other ARMs provide against payment shock. Other ARMs fix the rate for some period at the front end – the period can be as short as a month or as long as 10 years. On HELs, there is no initial fixed-rate period. If the prime rate changes on Monday, the rate paid by the borrower will change on Tuesday. HELs accrue interest daily.

Conventional ARMs, furthermore, reduce the size of any single increase in the mortgage payment with caps on the size of interest rate increases or payment increases. HELs have no adjustment caps.

Conventional ARMs also have maximum interest rates that are usually 5-8% above the initial rate. On HELs the maximum rate is generally 14-17% above the initial rate.

For all these reasons, HELs are the riskiest ARMs out there.

It is sometimes argued that the prime rate used by HELs is more stable than the rate indexes used by other ARMs, an argument that seems to be supported by the fact that the rate hasn’t changed since it hit 4% on June 27, 2003. But don’t be fooled by this very recent history. During the five year period January 1976-January 1981, the prime rate changed 84 times in going from 7% to 20%. In 1978 alone, it increased 15 times. In 2001, it declined 11 times.

Indeed, the recent stability of the prime rate in the face of rising rates on other mortgages signals greater, not less risk for the HEL borrower. The prime hit 4% in the last week of June 2003, when Freddie Mac reported an average rate of 5.24% on 30-year fixed-rate mortgages. One year later, Freddie reported an average of 6.28% and the prime is still 4%. That makes it more likely than not that the next change in the prime rate will be an increase.

Whether the risk is worth taking in any particular case depends primarily on 4 factors. The first is the rates at which you can borrow. The larger the spread between the initial rate on the HEL and the rate on the alternative mortgage, the stronger the case for the HEL.

The second factor is how long you expect to have your mortgage. Since the HEL rate is lower at the beginning but could be higher later on, the shorter the period you have the new mortgage, the stronger the case for the HEL.

The third factor is how rapidly you expect to pay down the balance during the period you have the mortgage. Making larger payments in the early years reduces the balances on which the potentially higher rates on the HEL in later years are applied. The higher the payments you expect to make in the early years, the stronger the case for the HEL.

The fourth, and by far the most difficult factor to assess, is how far and how fast HEL rates might increase in the future. You don’t know this any more than I do, so what we have to do is make a plausible assumption. My working assumption is that the prime rate to which the HEL rate is tied may increase by 1% a year for 5 consecutive years.

I’ll illustrate with Tom Prudence, who could get a HEL at the prime rate of 4%, and a 30-year FRM at 6.28% in early June, 2004. He is deciding between the two. Tom elects to use my assumption about future HEL rates, which means that the prime rate is assumed to rise from 4% to 9% over 5 years.

Given this rate assumption, we know that if Tom holds the loan only for three years, he will come out ahead with the HEL because the HEL rate will be below the FRM rate for the first three years. In year 4, however, the HEL rate will hit 7% and start to turn it around. Break-even occurs at about the 57th month. If he holds the mortgage longer than that, his total costs – the sum of payments plus lost interest less reduction in the loan balance – will be lower on the FRM than on the HEL.

If Tom makes extra payments in the early years, he lengthens the break-even period. For example, if he makes a payment calculated at 6.625% during years 1, 2 and 3, he extends break-even to 5 years. To extend it to 6 and 7 years, he has to make payments calculated at 9.15% and 10%, respectively.

HELs usually allow the borrower to pay interest only for the first 10 years. For reasons explained above, this option is counter-productive for a borrower looking to save money relative to a higher-rate FRM. The borrower who pays interest only will have the shortest possible break-even period.

Borrowers with very tight budgets and little in the way of a financial reserve have an additional reason for avoiding interest only on a HEL. If interest rates spike in the future, the IO payment jumps the most. For example, if the HEL rate stays at 4 % for 5 years, then jumps suddenly to 9%, the borrower paying interest plus principal (the "fully amortizing payment") will face a 59% increase in payment. But the increase for the borrower paying interest only will be 225%.

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