HELOC rates move closer to home equity loans

The spread between rates for home equity loans and home equity lines of credit, or HELOCs, has narrowed significantly since the Federal Open Market Committee began boosting rates in June 2004. The rate differential is now just over half of what it was last June.

Why has the rate difference contracted so dramatically in such a short period? The Fed has been raising short-term interest rates, which has a direct bearing on the movement of HELOC rates. Meanwhile, long-term interest rates, such as the 10-year Treasury note yield, actually declined before leveling off. Home equity loan rates are more closely related to longer-term benchmarks than the shorter benchmarks that have mimicked Fed interest rate moves.

How long will the difference in rates continue to contract? Look at how consistent the difference was from 1997 to 2000, a period that encompassed both rising and falling rates.

Only when the Fed began aggressively cutting rates in 2001 did the difference begin to expand. The spread increased fourfold in the one-year span between Jan. 3, 2001, and Jan. 2, 2002, moving from 0.76 percent to 3 percent, as the Fed cut short-term interest rates 11 times.

As the low-rate environment continued through the ensuing two and a half years, HELOCs were a bargain relative to fixed-rate home equity loans. With HELOC rates hitting record lows, the differential between HELOCs and home equity loans hit a record high. Homeowners cashed out more than $330 billion in home equity during those years, according to The Demos Group, with much of it being piled on low-rate lines of credit.

But now the advantage is disintegrating before our eyes. Since the Fed began raising interest rates in June, the average HELOC rate has climbed from 4.77 percent to 5.68 percent, while home equity loan rates have dropped from 7.22 percent to 6.95 percent. As a result, the difference between rates on home equity loans and lines of credit is now just 1.27 percentage points, much closer to the 1 percentage point spread seen between 1997 and 2000.

However, there is no guarantee that the difference will suddenly stabilize near 1 percentage point. In fact, the spread could narrow to a point not previously seen if long-term interest rates continue to defy expectations, remaining well below forecasted levels in 2005, while the Fed continues raising short-term interest rates. Such a circumstance seems unlikely, not only because of widespread forecasts that long-term interest rates will rise, but also because long-term interest rates at current levels are not consistent with continued economic growth. Long-term interest rates are at levels that indicate a crisis in economic confidence, which, if proven correct, would put the brakes on any further increases in short-term interest rates by the Fed.

HELOC rates will parallel further interest rate moves by the Fed. But the decision on which product to choose now depends a lot on how much higher you feel interest rates will go. If the Fed is indeed headed for a fed funds rate of 4 percent by 2006, then a HELOC currently at 5.68 percent could be 7.43 percent next year.

Compare this to the current average home equity loan rate of 6.95 percent. A home equity loan requires the entire loan amount to be disbursed at closing and payments of principal and interest begin thereafter. HELOCs, despite the risk of rising rates, enable borrowers to delay their borrowing until the funds are actually needed and borrowers retain much greater control over when and how quickly the principal is repaid.

The prospect of continued rate hikes spells higher rates on HELOCs. Whether or not this also leads to a big jump in home equity loan rates depends on economic sentiment as reflected in long-term interest rates. But even in a disadvantageous rate environment, HELOCs provide borrowers with much desired flexibility that installment loans do not.

Greg McBride is a financial analyst for Bankrate.com.