Dear Dr. Don,
I have a variable-rate home equity line with an interest rate that is a half percent below the prime rate, or at 2.75 percent. I owe $210,000 on a house valued at about $550,000. I'm trying to decide whether I should lock in at a slightly higher rate, fearing that rates might go up over the next several years. The payment amount is a minimum of 1 percent of the outstanding amount of the loan balance. To be honest, the main reason I am considering refinancing is to get a lower monthly payment. Any advice that you could provide on the matter would sure be appreciated.
-- Mark Makeover
You have a great rate on your home equity line of credit, also known as a HELOC. Most lenders require a floor lending rate, even when the loan is tied to the prime rate. Bankrate's current national average for a HELOC is above 5 percent with the prime rate at 3.25 percent. Even so, you face the risk of rising interest rates.
There's a dilemma, however. Short-term rates are likely to stay low over the next year or so. At the same time, the pricing of 15- and 30-year fixed-rate mortgages is tied to the 10-year U.S. Treasury note. Any upward pressure on these rates is more immediate.
A home equity line of credit that doesn't have a balloon payment typically becomes a self-amortizing loan at some point, usually five to 10 years after closing. At that point, the homeowner can no longer draw against the credit line, and the monthly mortgage payment increases enough to pay off the mortgage over the remaining loan term, around 10 to 20 years.
Since your lender requires a minimum monthly payment of 1 percent of the monthly balance, your current loan payment is $2,100. Some $481.25 of that is interest expense. A 15-year conventional fixed-rate mortgage at, say, 3.4 percent would result in a monthly mortgage payment of $1,493.02.
You should first review the terms of your current loan. Second, determine how much of your monthly income can be tied up in the mortgage payment.
If your goal is a lower monthly payment, switching to a conventional fixed-rate mortgage with a higher interest rate would get the job done. It won't have a 1 percent minimum payment requirement. You won't know whether it would result in lower total interest expense over the loan term because of interest rate risk associated with the home equity line. Rates could rise sharply, in a negative scenario.
If refinancing, one presumes that you plan to stay in the house for a long time, perhaps at least a decade. You'd pay closing costs on a new first mortgage and lock in a higher fixed rate. Short-timers don't face sufficient risk of higher rates to guarantee that refinancing is worthwhile.
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