||Ask Dr. Don
Prime time for the prime rate
Dear Dr. Don,
We are contemplating another land purchase (small
lot) and rather than financing with a typical land loan (with closing
costs), we are considering using a home equity loan (we have lots
of equity in our residence). We see a two-year window until we build
on this lot, and we will use the sale proceeds of our current residence
to pay off the land and pay outright for the house we build, thereby
ending up with no mortgage.
The question is this: The home equity loans we are
looking at seem universally to be indexed to the prime rate. We
don't see signs in the economy to suggest the prime moving wildly
in either direction before the end of 2004. But with 2005 and part
of 2006 to get through before we consolidate (pay off) the financing
on this next property, would we be taking a huge financial risk
with financing indexed to the prime rate? I would appreciate your
suggestions, gut reaction, etc.
I think you should set your interest rate worries aside and concentrate
on the bigger issues involved in building your new home. Come clean.
Would a LIBOR-based home equity line make you feel more at ease?
A home equity line of credit (HELOC) is a variable-rate
loan typically, as you point out, tied to the prime rate. The minimum
payments on a HELOC, at least in the early years of the loan, are
interest only, which helps reduce the strain on your monthly budget.
In contrast a home equity loan is a fixed-rate loan
with amortized payments that include both interest expense and principal
repayment. The home equity loan will eliminate the interest-rate
risk by committing you to a higher rate today. As I write this the
average rate on a HELOC is 4.70 percent and the average rate on
a home equity loan is 7.20 percent. You can view the current averages
Bankrate's Interest Rate Update.
I'd be surprised to see your prime-based HELOC loan
adjust to a level above the fixed rate on a home equity loan over
the two-year horizon that you plan to be in this loan.
The HELOC also lets you draw against the line as needed
instead of borrowing the money upfront. That keeps interest expenses
lower over time.
-- Posted: March 18, 2004