Home equity or refinance: Which is better for you?

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.

Pros

• In most cases, borrowers can deduct the interest on loans up to $100,000 on their taxes.
• The loans carry lower interest rates than credit cards and unsecured personal loans.
• They can be used for lots of things: debt consolidation, home improvements, tuition, medical costs, emergencies and big-ticket items.

Cons

• If you default, you could lose your home, your biggest asset.
• Such loans can be a risky spending tool for younger homeowners who are not established in their careers and have less experience owning a home and managing money.
• The loans can be risky for older homeowners who would be tapping their nest egg close to retirement.
• Credit lines have variable interest rates, so monthly payments can rise, even if your income doesn't.
• If your home's value drops, you can end up owing more than the house is worth -- a bad situation if you need to sell the house.
• Using an equity loan to pay off debt might make monthly payments cheaper but could cost you more in the long haul, because you're taking much more time to pay off the debt.
• You might not be able to lease your home during the term of your loan.
  

"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 ballBut 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 behaviorHome 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.

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 candidatesSo 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 years.

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 flexibilityBut 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.