January 30, 2004
Just when it seemed every offbeat variation of home loan had hit the market, along comes this: Lenders are now offering
to finance your house with just an equity line of credit.
So, in a world of skyrocketing home values and ultra-low interest rates, second mortgages have become first mortgages.
Vijay Lala, vice president at Countrywide Home Loans, says the loan was more successful in its first month than any other of his company's
new mortgage products. "And it's continued to gain momentum," he says.
Countrywide hit the market last summer with its version, the FlexSaver Adjustable Rate Mortgage. Other national lenders offering their own
versions include Quicken Loans, Washington Mutual and Amerisave. Creditworthy borrowers can find an initial interest rate below 4%, and
the loans offer the ultimate in monthly payment flexibility.
Bob Walters, vice president at Quicken Loans, says financing a home with an equity line can be particularly useful to business owners or
commissioned salespeople whose income arrives in fits and starts. Walters says they also can be attractive to home buyers expecting to
stay in the house for just a few years.
But the loans aren't for everybody. You could be setting yourself up for a quick need to refinance to a more traditional mortgage if
interest rates move up sharply. And using an equity line as your only home loan requires fiscal discipline, or your next move could be
from dream house to poor house.
Traditional equity lines. Normally, you'd take out a home equity line of credit to supplement your primary mortgage. Because they are
secured by your property, bankers are willing to extend the credit at a lower interest rate than most other kinds of loans. And interest
paid on an equity line is tax deductible, just as interest on a first mortgage is.
Your lender will open a credit line up to a specified limit determined by your home equity - your home value minus what you owe on your
first mortgage. The interest rate is subject to change monthly, as market interest rates change.
Flexibility and convenience are key attractions. You typically draw on an equity line of credit by writing a check. Buy nothing, pay
nothing. Run the balance when your expenses are high. Pay it down when you have a surplus of cash. The deals permit a borrower to draw
against the credit line for a specified period of, say, five years and pay only interest. At the end of the draw period, the loan balance
must be paid over the remaining term of the loan, say, 15 years.
What's new. More lenders are marketing equity lines to customers looking to buy a home or refinance. Say you want to buy a $250,000 house,
and you have $50,000 cash. You take an equity line for $235,000. Assuming you sink all your cash into the deal, you use $200,000 from your
credit line to pay for the house. That leaves unused credit of $35,000.
*Initial interest rates. Equity lines are pegged to the prime rate, a benchmark interest rate uniform across the lending industry. The
prime rate is now 4%. When the Federal Reserve Board changes short-term interest rates, banks move the prime rate with it. Three years
ago when the Fed changed directions on monetary policy, the prime started to notch downward from 9.5%. It's been resting at its current
low level for more than six months.
Competition among lenders has driven down the price of equity lines. They're making them available at rates very close to prime, and
sometimes even below.
Lenders typically express the price of an equity line as a constant spread above or below the prime rate. Example: A loan pegged
one-quarter percentage point below prime would result in an interest rate of 3.75%. If you want to snag a rate below prime, you'll
need an excellent credit history, limit your credit line to 80% of your house value and pay closing costs out of pocket.
*Transaction costs. The equity lines carry no points - upfront payments that reduce the interest rate. They do carry closing costs.
*Payments. In the first 10 years of the loan, the borrower may make interest-only monthly payments. On a $200,000 balance, a 4%
equity line would cost $667 a month. Keep in mind that you won't be building equity with your payments. But many borrowers these
days are comfortable with that if their home is appreciating in value and they have good alternatives for investing their money.
A day of reckoning arrives eventually with this or any other interest-only home loan. Typically, a lender requires repayment of the
loan principal starting in the 11th year of the loan.
*Flexibility. As with any equity line, the borrower has the option each month to run up the loan balance or to pay it down to a more
manageable level.
The ultra-low interest rate will look like a bargain only as long as the Fed keeps short-term borrowing rates low. A reversal of
Fed policy may be months away, or maybe years away.
Lenders acknowledge that a run-up in short-term rates could make these loans lose their luster. In the meantime, there's big money to
be saved on low monthly house payments, they say. Anyway, if interest rates move sharply upward, homeowners in recent years have found
that they're comfortable refinancing to a better deal the instant one presents itself.
Veso Dimitrijevich, 30, a project manager at Ford Motor, traded his 7% fixed-rate mortgage for a 4% equity line as the sole means of
financing for his Royal Oak, Mich., condominium. The prospect of a run-up in interest rates is not a worry, he says. He's carrying a
balance of just $82,000, so even a spike in rates wouldn't blow a hole in the household budget. And he and his wife plan to move in a
few years.
And the open credit line? It's not a temptation, says Dimitrijevich. He paid an extra $200 a month on his old mortgage to buy down
the principal. He says he plans to keep his monthly payment the same.
Keith Gumbinger of mortgage consultant HSH Associates questions whether some of the potential borrowers targeted for this type of
loan have the financial skills to manage unfettered access to their home equity.
Lala of Countrywide acknowledges that it's a complicated loan deal and that customers need to be careful. But, he says, "It's our
job to make sure they understand the terms."
Dave Herpers, consumer affairs director at Amerisave Mortgage, says borrowers may be safer taking out an interest-only mortgage and
pairing it with a separate equity line. The benefits are nearly the same - low interest rates and monthly payments - and, he says,
there's less chance that they'll run up their loan balance. "I don't think it's for the masses," Herpers says of financing with home
equity alone.
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