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Home equity lines of credit: Keep or refinance?

If you have a home equity line of credit, maybe you wonder what to do with it. Should you keep the credit line, even though the rate has almost doubled in 21 months? Should you refinance it? To answer, you will have to make a judgment call and probably do some math.

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Two years ago, a home equity line of credit looked like a great deal. Credit lines gave homeowners access to money at rates that were lower than those on fixed-rate home equity loans or first-lien mortgages. Cheap credit lines allowed borrowers to use their homes as ATMs to pay for home improvements, college tuition, cars and vacations.

But credit lines are indexed to the prime rate, and that means that borrowers' minimum monthly payments go up whenever the Federal Reserve raises short-term rates. The Fed has done so 15 times since the middle of 2004, raising the prime rate from 4 percent to 7.75 percent. Most observers expect the Fed to hike at least once more.

Monthly payment nearly doubles
The increases have hit consumers' checkbooks hard.

Take the hypothetical example of someone who borrowed $30,000 against a home equity credit line when the rate was 4 percent. Two years later, the same borrower still owes $30,000 because she has made only the minimum payments, which cover interest and not principal.

Now that the rate is 7.75 percent, the minimum monthly payment has risen from $100 to $193.75.

Credit lines are no longer the great deals they once were. The average rate on a credit line is now higher than the average fixed-rate home equity loan. And 30-year, fixed-rate mortgages are even lower.

Three choices
Borrowers have three options:

  • Keep the credit line.
  • Pay it off and replace it with a fixed-rate home equity loan.
  • Do a cash-out refinance on the first-lien mortgage and pay off the credit line with the proceeds.

Holding the (credit) line
A credit line has two advantages, says Michael Moskowitz, president of Equity Now, a mortgage lender in New York: It grants you flexibility, and you pay interest on the amount owed and nothing more. If those qualities are important, you might want to keep the credit line.

The archetypical user of a home equity line of credit, Moskowitz says (and, yes, he uses the word "archetypical"), is a self-employed homeowner "whose business goes up and down and they want to have in reserve a couple of hundred thousand dollars." The ready reserve of money helps smooth out the times when not a lot of money is flowing in.

That archetype has expanded to include people who need to borrow money periodically, using their house like a credit card -- homeowners who renovate their homes in stages, for example, or parents who pay tuition. For these people, the flexibility of a credit line outweighs the rising interest rate.

Ideally, these borrowers draw from their credit lines and then pay some or all of the balance before drawing against the credit line again. Using a credit line this way is cheaper than using a credit card, and the interest is tax-deductible.

"If they're not fully drawn out, and expect money to go in and out, they keep a home equity line of credit even though rates will keep going up," Moskowitz says.

On the other hand, someone who carries a balance on a credit line might want to embrace the discipline of being forced to pay it off, even if it's at a higher rate.

Refinancing into a fixed loan
If you can stand the higher payments, it might make sense to refinance the credit line into a fixed-rate home equity loan, says Anthony LaGiglia, a financial planner with J.J. Burns & Co. in Melville, N.Y. Right now, rates on home equity loans are roughly the same as those on home equity lines of credit. But home equity loans sport higher payments because the minimum payment includes interest and principal, and not just interest.

Next: " ... giving up a lower rate for a higher rate 'is a losing proposition.'
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