HELOC holders give Fed an ovation

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Among the fist-raisers in the Sept. 18 Federal Reserve announcement of a half-point interest rate cut are those holding home equity lines of credit. They’ll notice an almost immediate corresponding rate reduction.

Shoppers for home equity loans might see slightly lower rates, but those who have a loan won’t detect much difference, because home equity loans are usually fixed-rate and don’t react as closely to the federal rate cuts. The loans are more tied to market forces, which have already pushed fixed-rate loans down ahead of the Federal Reserve announcement.

“Overwhelmingly, home equity lines of credit are pegged to the prime rate, which is pegged to the federal funds rate,” says Richard DeKaser, chief economist with National City Corp.

Home equity loans, on the other hand, tend to move in sync with the federal funds rate, though they are not specifically pegged to it, DeKaser says. Loan shoppers “will see some decline, I’m sure, but not as much as the HELOC.”

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Lines of credit vs. loan
HELOCs give the borrower access to a certain amount of cash during a set number of years and typically carry a variable rate. Home equity loans, on the other hand, are closed-end and usually fixed-rate, providing the borrower with an immediate lump sum. Both are commonly referred to as second mortgages.

Depending on the terms of their original loan, those who already have a home equity loan could refinance into a HELOC or another loan, says DeKaser. “A common feature of home equity loans is a prepayment penalty, which could exceed any savings.”

HELOC vs. home equity loan
HELOC Home equity loan
Money is dispersed as needed, may have mandatory dispersal to open.
Take money in one lump sum.
Generally, no closing costs.
Often carry closing costs.
Interest rate is usually variable, subject to ups and downs of rates.
Interest rate is generally fixed for life of loan.
Generally, interest paid is tax-deductible.
Generally, interest paid is tax-deductible.

Check your loan paperwork before contacting the lender to gauge your ability to refinance into another loan or a HELOC, advises Bernard Markstein, senior economist with the National Association of Home Builders.

Historical perspective
The Federal Reserve’s rate cut to 4.75 percent last week marked its first rate decrease since June 25, 2003. Back then, it tried to spark economic growth by dropping the rate to 1 percent, a 45-year low, where it stayed for a year. Over the next two years, the Fed raised the target rate a quarter of a point 17 times in a row until June 2006, when it halted at the 5.25 percent rate, where it remained until Sept. 18.

The average interest rate for a home equity loan has hovered around 8.06 percent and 8.22 percent for a HELOC during the third quarter of this year, according to Bankrate’s national rate information. That compares with an average rate in mid-July for a 30-year fixed-rate mortgage of 6.82 percent. Last week, that average dropped to 6.32 percent.

Rate comparison by quarter

Equity loans more popular with housing boom
The housing boom and bust has corresponded with the rise and fall of people seeking second mortgages, says DeKaser. During the years preceding the 2005 peak in home prices, homeowners flocked to HELOCs and home equity loans.

In markets experiencing housing bubbles, such as Washington, D.C., Florida and California, Markstein says second mortgages were popular as a way to avoid the higher rates and lower availability of a jumbo loan.

Jumbo, or nonconforming loans, are above the $417,000 federally-insured limit set by the Federal Housing Administration. Many borrowers chose to finance expensive real estate through a first mortgage for the bulk of the purchase price and a second mortgage for the remainder. This is commonly referred to as a “piggyback loan.”

In the bust that’s followed the boom, as home values have declined, borrowers who are still able to make payments on two mortgages have not suffered, in part due to a relatively healthy labor market, DeKaser says. However, if property values continue to decline, ending up below the mortgage value, homeowners who are fully borrowed on their first and second mortgages may have “a disincentive to stay current on payments,” he adds.

Lending standards still tight
The FOMC rate cut’s impact on housing is varied, and will be felt immediately in some sectors, says Markstein. “A few weeks ago, we were seeing some real problems in the financial market with mortgages,” he says. Investors were shying away from buying mortgages on the secondary market because of the subprime crisis. “We were looking at a cut-off of money toward mortgages, which would have made a bad situation worse.”

“The Federal Reserve provided needed cash to the mortgage market,” says Markstein. “It has calmed down the financial markets, and it appears we’re no longer under the threat of a mortgage meltdown. At a minimum, the situation won’t get any worse.”

Standards for obtaining first and second mortgages are still tougher than they were in the past few years, Markstein says, because lenders were stung by borrowers who walked away from — or were unable to pay — loans that exceeded the value of their homes.

“Let’s not sugarcoat this,” he adds. “The days of being able to take all the equity out of your home are gone forever, or at least we hope forever.”