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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.
Rebecca Rate

Dear Rebecca,
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?

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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 in 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

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See Also
HELOC vs. home equity loan
Second thoughts about second mortgage
Financial advice glossary
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Home Equity
Compare today's rates
$30K HELOC 4.59%
$50K HELOC 4.09%
$30K Home equity loan 4.87%
Rates may include points

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