Line blurs between home equity loans, lines of credit
The line is blurring between the fixed-rate home equity
loan and the variable-rate home equity line of credit.
When you borrow against your home's equity, you generally
have to choose either the equity loan, which you pay off with equal
monthly payments over a specified period, or the equity line of
credit, which has a revolving balance like a credit card and minimum
monthly payments that cover only the interest.
The last few years have seen the introduction
of hybrids that carry elements of both equity loans and equity lines
of credit. One of the more unusual of these is Wells Fargo's SmartFit
Home Equity Account.
The loan that morphs
SmartFit starts out as a fixed-rate home equity loan, then morphs
into a variable-rate line of credit. The borrower can choose to
fix the initial rate for three, five or seven years. During the
fixed-rate period, the minimum monthly payments cover only the interest,
although the borrower has the option of paying back some of the
At the end of the fixed-rate period, the remaining
balance automatically becomes a home equity line of credit, or HELOC,
unless the borrower pays it off in full or converts the balance
into another fixed-rate loan. The HELOC's rate adjusts whenever
the prime rate changes.
If you are familiar with adjustable-rate mortgages,
or ARMs, you can see that SmartFit is similar to a hybrid ARM. A
hybrid ARM has an initial fixed rate that lasts for a set number
of years (usually three, five, seven or 10), then adjusts annually
thereafter. A traditional ARM typically has its first rate adjustment
after one year.
Pay more, risk less
There's another similarity between hybrid ARMs and SmartFit: the rate
structure. The initial interest rate on a hybrid ARM is higher than
that for a traditional ARM, but lower than the rate on a 30-year fixed
mortgage. Likewise, the initial rate on the SmartFit is higher than
that for a typical HELOC, but lower than the rate on a home equity
The initial rate on a SmartFit loan depends on several
criteria, including the borrower's credit score, the length of the
fixed-rate period, the ratio of all the mortgage debt to the home's
value, and whether the monthly bill is paid automatically via electronic
transfer. A person with excellent credit who chooses a three-year
fixed period could get a rate at 99 basis points over prime, or
That same borrower probably could get a HELOC at
5.25 percent or 5.5 percent or a home equity loan at around 6.75
percent to 7 percent. The initial rate on the SmartFit is in between,
with a rate that won't rise for three years. Meanwhile, HELOC rates
are expected to climb as the Federal Reserve lifts short-term rates.
An equity loan structured like SmartFit should appeal
to the same people who take out hybrid ARMs to buy their homes.
A prime candidate for a hybrid ARM would be someone who doesn't
expect to live in the house for more than a few years before moving
SmartFit "is for those customers who really
are concerned about rising rates and who want to keep their financing
costs reasonable, but don't want to take the risk ... to subjecting
themselves to a continually escalating prime," says John Barton,
executive vice president of Wells Fargo's consumer credit group.
He says the loan program is a good fit for homeowners
who are tackling major house renovations or need the money for tuition,
medical expenses or "bigger kinds of one-time or larger multiple
kind of purchases."
Interest charged on entire loan amount
Compared with a HELOC, SmartFit has one major shortcoming: you pay
interest on the entire amount from the get-go. With a HELOC, you pay
interest on the loan balance, not on the entire line of available
credit. For example, you might have a credit line of $50,000, but
if you borrow $10,000 of it, you pay interest on just the $10,000
-- not on the $40,000 of available credit that you haven't used. With
SmartFit, you get all the money in a lump sum, whether or not you
need all of it at the beginning, and you pay interest on it.
On the other hand, the rate on a SmartFit is lower
than on a comparable home equity loan, which is received as a lump
sum. The monthly payments on a home equity loan include principal,
while the minimum payments on the SmartFit cover only the interest.
That makes SmartFit more flexible (because you can choose whether
or not to pay toward principal each month), but potentially hazardous
for borrowers who lack self-discipline.
Wells Fargo and other lenders, including Washington
Mutual, offer another fixed-rate option for HELOC borrowers: They
allow you to set aside a portion of a home equity line of credit
and pay a fixed rate on it, paying off that slice of the loan over
a set period. For example, if you can have a $50,000 line of credit,
and you want $20,000 to buy a car, you can borrow that amount out
of the HELOC at the prevailing rate for a home equity loan and pay
it off over five years.
"The appeal is matching the purpose of
the money with the term and the payment schedule," Barton says.