Grab cheap home equity rates now, land higher risk later

Hundred dollar bill folded in shape of a house

Though low interest rates might make a home equity line of credit look attractive right now, there’s no question that they’re risky, even for disciplined borrowers.

Indeed, you'll pay just about 5.15% for the average home equity line of credit, or HELOC, according to our survey of major lenders.

That's about as cheap as we've seen these loans since early 2009.

In some cities, borrowers with excellent credit can find home equity rates of 4.5% or less.

That's considerably less expensive than most other consumer loans, and the interest is usually tax-deductible, which is one reason why so many people use equity to finance home renovations, new cars or their kid's college tuition.

These variable-rate loans allow homeowners to borrow against the equity in their homes on an as-needed basis.

But as thousands of borrowers will learn in the next five years, low rates and a decade of minimum payments come with a cost.

About 60% of those who borrowed during the boom years are about to see their monthly payments increase substantially, according to a recent report from the Office of the Comptroller of the Currency.

That's because the "draw period" -- typically the first 10 years of the loan where borrowers are only required to pay the monthly interest -- is about to end for many homeowners who took out loans between 2003 and 2008 when equity was surging.

Not only are these borrowers going to have to grapple with higher monthly minimum payments as they must start repaying principal, they'll also face potentially rising interest rates for these adjustable-rate loans and limited refinancing options because their homes are worth so much less.

Some just won't be able to afford the payments and will be forced to sell their homes, or worse, go into foreclosure.

Suddenly, all those home equity-financed granite countertops and stainless-steel appliances don’t look so shiny.

Still, if you can manage to pay down principal during the draw period, HELOCs can be a good way to borrow.

And there's some evidence banks are making it a bit easier to get approved for a home equity loan by loosening underwriting standards that were tightened following the financial crisis.

Between February 2011 and 2012, some 18% of lenders reduced the loan-to-value ratio and credit scores they require on HELOCs, according to the Office of the Comptroller of the Currency report.

Still, lenders might require borrowers to maintain as much as 20% of their equity after taking the HELOC into account.

That leaves out a lot of homeowners who are underwater or who have little equity.

To figure out what size HELOC you can get, subtract the balance you owe on your mortgage from what your home is currently worth. Your equity is the difference between what your home is worth and how much you owe.

If, for example, your home is worth $200,000 and you owe $140,000 on your first mortgage, you’d have 30% equity, or $60,000.

If the borrower required you to retain 20% of that equity, or $40,000, your HELOC would allow you to borrow a maximum of $20,000.

Many lenders won’t extend a HELOC for less than $10,000.

If you borrow today, rates are likely to stay cheap for some time. That's because HELOC rates are based on the prime rate -- the floating interest rate banks charge their best commercial customers -- plus a margin.

The prime rate has held at a six-decades low of 3.25% since 2008. It’s expected to remain there until at least late 2014, thanks to the Federal Reserve's efforts to drive down interest rates.

But when rates increase, the variable rate on HELOCs will increase, and money homeowners have already borrowed will become more challenging to pay back.

Most banks cap the cost of such loans; current caps range from 18% to 24% at the big banks.

We’re far from having to worry about such high interest rates, but even a jump from 5% to 10% could be devastating.

A traditional home equity loan may be a safer borrowing option.

Unlike a HELOC, it requires you to borrow a lump sum all at once. However, it's a fixed-rate loan that requires you make the same payment each month until the debt is retired, much like a mortgage.

It's a good option if you want to borrow a specific amount for a one-time project.

In exchange for the security of knowing your interest rate, you’ll pay a bit more for a home equity loan. The average home equity loan costs about 6.38% right now, according to our lender survey.

That’s a good interest rate. In fact, it's a record low for this type of loan.

For about 1.25% more, you’ll know exactly what your monthly payments will be until you retire the loan. But your home will still be loan collateral.

You might think, “Why not get the lowest possible interest rate now, then refinance into a sure thing when rates start to go up?”

Ask all the folks who are underwater and have adjustable rate mortgages. You can’t always refinance when you want to.

Your home’s value could decline between now and then, leaving you without the equity you need to refinance. You could lose your job and not have the income lenders require. Your credit score could plummet. Lending standards could tighten up again.

If you decide to go with a HELOC anyway, you can reduce your risk by starting to repay the principal immediately and not paying interest only, regardless of what your loan agreement requires.

Our line of credit calculator can help you do the math and determine how long it might take to pay off your credit line.

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