Monday, August 14, 2006

Rainy day fund

When the Federal Reserve decided to leave short-term interest rates untouched last week, homeowners were high on the list of beneficiaries. And the millions of them with outstanding home equity lines of credit tied to the prime rate got the most immediate relief: No increase on their next monthly payments for the first time in two years.
According to bank industry data, rates on outstanding home equity credit lines now average 8.74 percent. Two years ago, by contrast, the average was 4.68 percent. Most equity credit lines are priced at prime plus anywhere from one-half a percent to two percentage points. Prime currently is 8.25 percent. People with high credit scores -- 750 FICOs and higher -- often qualify for equity line rates slightly below prime -- anywhere from prime minus a half to prime minus one point.
But even homeowners among the credit elite have seen their equity line costs nearly double during the past couple of years, putting pressure on household finances. That steady drumbeat of rate hikes has prompted large numbers of borrowers to bail out of their credit lines and move their debts into their principal home mortgages at lower fixed rates.
To accomplish that, they've often refinanced their main mortgages, and cashed-out extra money to pay off their credit lines. Say you had $75,000 outstanding at 8.75 percent on your floating-rate credit line and were growing unhappy with the constant rate jumps. Say you also have plenty of equity in your home -- an existing first mortgage of $300,000 at 6.25 percent and an appraised market value on the house of $600,000.
With 30-year fixed rate conforming mortgages averaging about 6.5 percent last week, you could cash out your $75,000 by refinancing into a new first loan of $375,000 or higher at 6.5 percent. If you were willing to roll your closing costs into the new loan amount, you could do the whole transaction with little or nothing out of pocket and end up with a rate around 6.75 percent. Most important of all: You would have ended your exposure to constant rate increases on your home equity debt.
Enough homeowners around the country have been refinancing into larger mortgages this year that Freddie Mac, the congressionally-chartered home loan giant, says that nearly 9 out of 10 of all new refinancings now involve cashouts. Some borrowers are refinancing to escape rising costs on other forms of adjustable-rate mortgage debts -- especially popular option-payment ARMs heading for rate resets, but most are simply rolling their equity lines into larger fixed-rate first mortgages.
Now that the Fed has put the brake on short-term rate increases, the pressure should be less intense on homeowners with credit lines to convert their debt to fixed-rate through refis. But with the prime sitting at 8.25 percent, will equity credit lines still attract new customers? The deputy chief economist of Freddie Mac, Amy Crews Cutts, thinks so. Even though her firm is not a participant in the national equity line business, Cutts is a big fan of equity lines, but with a twist.
"I think they are a great insurance policy," said Cutts in an interview with Realty Times. "You can take one out for little or no cost and then let it sit there" for use only in a financial emergency.
Some banks pay all closing and origination costs on new lines, but require at least a modest drawdown within the first two or three years. So you can have a $50,000 or $100,000 credit line sitting with a nominal rate of 8.25 percent, but it costs you nothing unless and until you pull out some cash. Cutts's equity-management concept in a nutshell: Credit lines for all households who qualify for them, but only to be used as a form of financial insurance policy. Sort of a rainy day equity tool for heads-up homeowners.


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