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2006: A look back - A look ahead  
  Two events that accelerated home equity debt in recent years appear to be fading.
 Home equity
 Personal finance calendar  Personal finance calendar 

Equity loan rates in 2007 are anyone's guess

Two events accelerated home equity debt in the early years of this century, and both appear to be fading away.

The first thing that got the equity train rolling was when mortgage lenders started pushing piggyback loans to help borrowers avoid paying mortgage insurance. The second impetus was when interest rates on home equity lines of credit plunged and then remained low for years.

Now, federal regulators are casting a cold eye on some piggybacks. And in the middle of 2006, rates on home equity lines of credit reached their highest in more than five years and have since remained there.

To understand the logic behind piggyback loans, you have to understand what mortgage insurance is all about. Put yourself in a lender's shoes. You know from experience that borrowers are more likely to end up in foreclosure if their down payments are small. Someone making a 10 percent down payment is more likely to default than someone who made a 15 percent down payment, and someone making a 5 percent down payment is riskier still.

Lenders drew the line at 20 percent. Anyone making a down payment of less than 20 percent would have to pay mortgage insurance. There are various types of mortgage insurance. Most require monthly premium payments and others come in the form of lump sum payments. Federal Housing Administration, or FHA, insurance is a combination of lump sum and monthly premiums.

Mortgage insurance is expensive, and it's not tax-deductible.
(Editor's note: Subsequent to the publication of this article, the rules on mortgage insurance changed so that, under some conditions, it is deductible.)

But there's a loophole. If you borrow your 20 percent down payment as a home equity loan or line of credit, you can get a loan for 80 percent of the purchase price without having to pay mortgage insurance. That combination of a first mortgage and a "piggyback" equity loan almost always had a lower total monthly payment than a loan with mortgage insurance. And the mortgage interest on the equity debt was tax-deductible.

But in 2006, federal regulatory agencies issued guidelines to lenders that cautioned them not to go overboard with issuing piggyback loans, especially in conjunction with pay-option and interest-only adjustable-rate mortgages. Such a combination "exposes financial institutions to increased risk," regulators said.

The guidance issued by the regulatory agencies is likely to force lenders to tighten their standards for issuing piggyback loans on top of pay-option and interest-only ARMs. That will result in a reduced number of equity loans.

Another factor has been working against equity debt for a couple of years: The Federal Reserve started raising short-term interest rates in the middle of 2004. That sent the prime rate higher, and home equity lines of credit, or HELOCs, are indexed to the prime rate. Every time prime went up, HELOC rates went up.

That wasn't a problem early in the rate-raising cycle, when the average rate on a HELOC went from about 4 percent to 4.25 percent and then to 4.5 percent. But in the spring of 2005, the average HELOC rate rose above the average rate on a 30-year mortgage and the HELOC rate kept rising. Rates on fixed-rate home equity loans were even higher, so there wasn't a lot of incentive for people to refinance their HELOCs into home equity loans.

Most economists believe the Fed will keep short-term rates steady for a while, and then start cutting rates sometime in 2007. But these predictions by economists are notoriously unreliable. Will rates on HELOCs and home equity loans go up, down or remain about the same in 2007? It's possible that they'll do all three at various times of the year.

-- Posted: Nov. 1, 2006
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