Home equity or refinance: Which is better for
Looking to refinance your first mortgage
and take cash out at closing? There may be a better deal for you.
When the prime rate is below the average rate charged
on 30-year fixed mortgages, consumers looking to tap their home
equity may find it cheaper for them to get equity loans or lines
of credit. Besides costing thousands of dollars less in closing
costs, the rates on these loans may be lower than first mortgages.
Before rushing out to a lender, though, consumers
should take stock of why they're borrowing and which loan makes
the most sense for them. While home equity loans and lines of credit
are currently attractive, they still aren't always the best option.
"It's good for someone who has to make a purchase
and they know they're going to pay it off in a few years or they
may want to move out in a couple of years," said Jim Cosman,
managing director for consumer finance and executive vice president
at Philadelphia-based Sovereign Bancorp Inc.
"But once you get a bigger dollar amount, the
line starts to cross," he added. "If I need a longer time
to pay this off in order to keep my payments reasonable, if I can't
afford a five-year or 10-year repayment schedule, I may need to
go with a mortgage."
First mortgage rates traditionally are the lowest
rates around. Banks and loan investors feel the most secure with
these loans because they have first lien position, which in English
means they get first dibs on any money generated through foreclosure
of deadbeat borrowers' homes.
When first mortgage rates are lower than equity loan
rates, it usually makes sense for a borrower to tap equity by going
through a so-called cash-out refinance. In that process, the customer
refinances the first mortgage, increases the balance and receives
the difference between the old and new balances in cash at closing.
The rate curve ball
But rates don't always behave normally. Sometimes, the interest
rate market throws borrowers and banks a curve ball. When that happens,
equity loans can actually end up being cheaper than first mortgages,
even though most equity loans are riskier because they're usually
in the second-lien position.
The reason lies in the way banks set rates on various
home loan products. Most first mortgages are bundled into mortgage-backed
securities, or MBS, and sold into the secondary market via Fannie
Mae and Freddie Mac.
Because of this process, bond market traders and the
MBS yields -- rather than any banker, broker, lender or even, to
a degree, Federal Reserve Board Chairman Alan Greenspan -- control
what happens with first mortgage rates.
Wall Street bond traders operate the same way
stock market investors do. They're constantly trying to figure out
what's going to happen next in the economy, not what's already taken
When the Fed cuts rates, it usually helps the
economy recover. So bond traders start to drive mortgage rates higher
in anticipation of an eventual recovery -- even though the Fed may
still be cutting the rates it controls directly and the economy
hasn't improved yet.
Home equity behavior
Home equity loans work differently, though. For one thing, banks
have more say over the rates charged on those because they typically
keep the loans on their books, rather than sell them off to third-party
For another thing, banks use yields on shorter-term
bonds, such as two-year or five-year Treasuries as a guideline for
their equity loan rates rather than yields on long-term MBS. Those
shorter-term yields are much more sensitive to the level of the
Fed-controlled fed funds rate than they are to the long-term economic
As for home equity lines of credit, most banks
set their rates based on the shortest-term market rate of all, the
Wall Street Journal prime rate. It moves in lock step with
the fed funds rate.
The Fed has raised short-term interest rates
twice this year by a total of one-half percentage point, and is
expected to continue raising rates. This is pushing rates on home
equity lines of credit higher for both new and existing borrowers,
as HELOCs carry variable interest rates.
But equity loans and lines of credit usually
come without closing costs, so they can be $2,000 or $3,000 cheaper
than first mortgages.
"It is relatively rare," said Vickie Hampton,
associate professor of family financial planning at Texas Tech University
in Lubbock, Texas. "But if you can get as much money as you
need with good terms on a home equity loan as you can on a mortgage
refinance, and you can get a rate that's attractive and lock it
in, then that seems like a very wise thing to do."
The best equity candidates
So who should go for an equity loan or line of
credit rather than a cash-out refinance mortgage?
Consumers who plan to pay off their loans in a reasonable
amount of time and those who don't need to borrow much money make
good candidates. That's because banks offer their lowest rates on
shorter-term equity loans.
Long-term equity loans tend to have rates that are
higher than fixed-rate mortgages, even when the prime rate is low.
And, customers who need $75,000, $100,000 or more will usually find
they need loans with longer amortization schedules to keep their
payments affordable. Most equity loans amortize over 10 years or
15 years, while many first mortgages amortize over as many as 30
Customers who took out first mortgages during periods
of extremely low rates may want to consider equity loans or lines
of credit too. It doesn't make sense to refinance into a new first
mortgage at a larger balance and higher rate and pay a couple thousand
dollars in closing costs to do so.
"If you've got a favorable rate on a first trust
deed mortgage, something in the 6s thereabouts or low 7s, you don't
want to pay off a $100,000 mortgage to take out $20,000 and raise
the rate on the whole amount," said Richard West, senior vice
president and division manager at San Francisco-based UnionBanCal
Corp. "You're much better off borrowing $20,000 and keeping
the first mortgage.
"Each individual has to do the math and decide
which way to go."
Customers willing to bet the economy will remain weak
for a while may want to look first at equity lines of credit. If
the Fed doesn't raise rates for a long time, the prime rate will
stay low as well.
That's what happened between December 1991 and May
1994, when the prime rate remained below 7 percent and bottomed
for many months at 6 percent. Someone who borrowed via a 30-year
mortgage refinance at the beginning of that time period, by comparison,
would have been stuck with an 8.25 percent interest rate.
Line of credit flexibility
But even if that doesn't happen, lines of credit
offer more flexibility than first mortgage refinances. Equity line
borrowers only pay interest on what they borrow. If rates look like
they're going to rise in a few months, they can pay off what they
owe, then not carry a balance until the prime rate and the rates
on their lines come back down.
Cash-out refinance customers get all their money up
front and have to pay interest on the entire balances of their loans
until they're paid off.
"The HELOC gives them a lot more flexibility,"
said Vijay Lala, executive vice president for product development
and support at Calabasas, Calif.-based Countrywide Credit Industries,
Inc. "It gives them what amounts to a flexible mortgage."
When borrowing with equity loans or lines of credit,
borrowers should watch out for additional closing costs some lenders
charge when those loans are in the first-lien position.
Banks agree to waive costs on equity loans and lines
of credit because they don't have to perform many of the same closing
and underwriting steps required on first mortgages. Many opt for
computerized property valuations rather than full appraisals, for
instance, and order title searches, but not new title insurance.
But when someone owns a house free and clear, there
aren't any recent mortgage documents and safety checks to fall back
on. So, some lenders go through the same steps they undertake on
first mortgages and stick customers with the bill.