Real Estate Chronicle

Home-equity lending has boomed in recent years as record numbers of consumers have taken advantage of low rates and rising home values to fund their spending needs, or to pay off high-cost debts. Borrowing against home values added $600 billion to consumers' spending power last year, according to Federal Reserve calculations, with about one-third of that sum coming from home-equity loans and lines of credit. But rising short-term interest rates have put a damper on the rapid ascent of the home-equity market. The value of home-equity lines of credit at commercial banks increased 17 percent in September over the previous year, according to the Federal Reserve. That was well below the 45 percent annual growth rate seen last fall. On a month-to-month basis, home-equity line balances, which totaled $438.7 billion at the end of September, have been basically flat since the end of July [source: http://www.federalreserve.gov].

The surge in home-equity borrowing has been driven mainly by the rising popularity of home-equity lines of credit, which give homeowners the right to borrow up to a certain amount, either all at once or as needed. Home-equity loans provide borrowers with a lump sum and a fixed rate. But rising interest rates have made home-equity lines of credit less attractive than they were as recently as the summer of 2004, when the prime rate was just 4 percent. What's more, the rate difference between a home-equity line of credit and a fixed-rate loan has narrowed, because short-term market rates have risen faster than long-term rates. And as rising rates begin to pinch borrowers' pocketbooks, the number of homeowners paying off their credit lines has increased. In fact, industry sources reveal that the number of borrowers prepaying their credit lines has climbed 50 percent this year compared to the same period in 2005. As a result, some borrowers are opting for more predictability.

Lenders, moreover, have introduced new features that allow borrowers to lock-in the rate on some or all of their credit line. Fixed-rate home-equity loans typically make more sense for borrowers who have a one-time need for cash, such as paying off credit-card debt or consolidating existing auto loans. A home-equity line, on the other hand, can be a better choice for someone who needs the money over time, for example, to pay college tuition fees or fund a long-term remodeling project. That's because borrowers pay interest only on the money they have actually drawn from the line of credit. They also can elect to make interest-only payments during the early years.

In essence, if selling is not a viable option, there are basically four approaches to follow so as to minimize costs in the wake of rising interest rates:

[ ] Home equity lines of credit.

They still make sense for borrowers who do not need cash all at once. Though vulnerable to higher interest rates, the borrower only pays interest on the amount of money actually drawn out.

[ ] Fixed-rate options on home-equity lines.
Allow borrowers to lock-in the rate on some or all of their line of credit. This can provide a hedge against rising rates, while maintaining a borrower’s ability to tap the credit line as needed.

[ ] Home equity loans.
Provide borrowers with a lump sum and a fixed rate. Borrowers are protected against rising interest rates, but must pay interest on the full loan amount even if they spend only a portion of the money.

[ ] Cash-out refinancing.
Allows borrowers to pull out extra cash when refinancing the mortgage. Whether this makes sense depends in part on the rate of the existing mortgage and the cost of refinancing.