Home Equity Loans Pricey But Not Going Higher

The cost of borrowing against your home is as expensive as it's going to get �" at least for the foreseeable future. Two years of relentless rate hikes that nearly doubled the cost of borrowing against your house are over.

Our survey of major lenders shows the average cost of a home equity line of credit has held below 8.25%, while the cost of a traditional home equity loan has leveled out somewhat short of 8%, over the past several months.

While the surge in interest rates is on hold for now, it has justifiably dampened demand for these popular loans.

Let's say you owed $20,000 on a line of credit and could afford $300 a month to pay it back.

In January 2004, when the average rate was just 4.39%, your loan would have been paid off in a little over six years and cost you $2,968 in interest.

That same loan at today's rate of 8.13% would take seven-and-a-half years to pay off and the interest would run about $6,765.

We literally borrowed hundreds of billions of dollars against our homes by taking out home equity lines of credit when rates were around 4% in 2002 and 2003. But rates began rising in June 2004 and HELOC debt peaked in November 2005 when rates were still under 7%.

Since then the total borrowed against our homes has fallen sharply.

Home equity rates rose because the Federal Reserve Bank had been fighting inflation.

With consumer prices rising more quickly than they have in a decade, the Fed raised the interest rate it charges commercial banks to borrow money a record 17 times between June 2004 and June of 2006.

Lenders passed those increases along to us by raising the rates on all sorts of consumer loans. The idea is that higher rates cause us to borrow less and spend less, making it more difficult for manufacturers and service providers to raise prices.

As a result, the rate that banks charge their best customers for loans, the so-called “prime rate” has gone from 4% in June 2004 to 8.25% today.

HELOC rates have followed right along because they are closely tied to the prime rate. You've seen the ads in your bank. They often promise a home equity line of credit at “prime plus 1 percent,” "at prime" or even “1 percent below prime.”

The latest report indicates the Fed’s efforts are working. The Consumer Price Index has been fairly benign over the past few months, and for all of 2006 the CPI rose only 2.5%, which is well below the 3.4% increase in 2005. The first report for 2007 was above estimates, with the CPI for January climbing 0.2%, due to increases in the prices of food, medical supplies and tobacco.

The core rate, which eliminates volatile food and energy prices, closed out 2006 at 2.6% -- much higher than the Fed's “comfort level” of 1% to 2%. It also is far above the 2.2% increase in 2005. The core rate for January 2007 rose 0.3%, pushing the reading for the last 12 months up to 2.7%.

The Fed’s rate-setting committee has not raised rates since June 30, 2006 and it is not expected to. Economists now believe the committee will stand pat well into the spring.

That should help homeowners with a home equity line of credit, or those who want to take out a traditional home equity loan.

Lines of credit allow you to borrow a percentage of the equity you have in your home, but you only have to pay for what you use. For example, if you took out a $30,000 line of credit and used $5,000 to upgrade your bathroom, you would only have to pay interest on that $5,000.

You can pay off, re-borrow and pay off the balance as many times as you like over the life of the credit line, which is typically five or 10 years.

That's usually followed by a 10- or 15-year repayment period during which you can't borrow any more and must repay the balance.

Although HELOCs are relatively inexpensive to obtain, they are variable-rate loans and rates can change quickly �" as so many borrowers discovered over the past two-and-a-half years. Some HELOCs offer a fixed repayment plan at the end of the draw period, which may or may not be an advantage, depending on which way rates are moving at that time.

A home equity loan, on the other hand, is a fixed-rate loan, which usually has a lower rate than a HELOC. A home equity loan is good if you need money right away for a set purpose.

You begin making payments 30 days or so after closing, much like you would on a mortgage. The home equity loan has many of the same closing costs that a mortgage has, as your home is collateral for the loan.

Because these loans are secured by your home they are second mortgages, and the interest that you pay is usually tax deductible up to $100,000 (or $50,000 if single or married and filing separately).

The money doesn't have to be used for a home-related project, however. It can finance a college education, the purchase of a new car or pay off high-interest credit cards.

There is one thing to remember. A home equity loan or a home equity line of credit puts your home at risk. Therefore, they are not loans to be entered into lightly.