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Home
equity or refinance: Which is better for you?
By
Michael D. Larson
• Bankrate.com
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
place.
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
investors.
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
outlook.
(continued on next page)
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