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Home Equity Loans - As rates rise, so do the stakes in home equity borrowing

There are many differences between home equity loans and home equity lines of credit, or HELOCs. For one thing, equity loans have fixed rates and HELOCs have variable rates. The Fed's policy of raising rates is enough to tip some borrowers toward getting fixed-rate equity loans so they won't have to pay ever-rising rates on HELOC balances.

A year ago, E-Loan was underwriting about two HELOCs for every home equity loan, says Sedrick Tydus, E-Loan's head of home equity lending. In late summer, it was almost an even split: about 11 HELOCs to every 10 home equity loans. "That does show there is movement to less risk," Tydus says.

By "less risk," Tydus means that those homeowners are choosing the sure thing -- fixed rates -- over variable rates that seem destined to go up. But those borrowers are opting for another sure thing: paying higher rates now. That's because the fixed rates on equity loans are higher than the variable rates on HELOCs. In Bankrate.com's weekly rate survey conducted Dec. 1, the average rate on a new home equity loan was 6.89 percent, compared to the average rate on a HELOC of 5.34 percent.

A consumer who selects a home equity loan over a line of credit is paying, on average, a rate that's 1.55 percentage points higher. Is paying the higher rate worth the extra cost? It is if you expect rates on HELOCs to rise another 1.75 percentage points. At the pace that the Fed is raising rates, that could take almost a year -- but only if the Fed doesn't take its foot off the brake.

Most HELOCs are tied to the prime rate, which started the year at 4 percent and is now 5 percent, thanks to the Fed's rate-hike campaign. People who get home equity loans are betting that the Fed will continue raising, making today's equity loans look like bargains in coming years after HELOC rates have climbed a few percentage points.

The Fed's rate-setting committee meets eight times a year. It has increased the federal funds rate by a quarter-point in each of the last four meetings. Economists wouldn't be surprised if the Fed pauses at some point, going a meeting or two without raising rates. Two or three such pauses could mean that HELOC rates wouldn't exceed today's home equity rates until 2006.

How long will you stay?

When you're deciding between a home equity loan and a line of credit, there are other things to consider beyond the Fed rate-hike crystal ball. The first question is this: How long do I plan to remain in this house? If you think you'll sell the house within five years, the equity line of credit probably is the better way to go.

"It's the same logic that a client uses whether to take a 30-year fixed loan or a 3/1 ARM," says Sue Baxter, branch manager in Westport, Conn., for MortgageIT.

In Baxter's analogy, a home equity loan is like a 30-year fixed first mortgage: You pay a higher initial rate, but you are protected from rising interest rates in the future. An equity line of credit is like an adjustable-rate mortgage, or ARM: you pay a low initial rate that can climb. In Baxter's example of a 3/1 ARM, the initial rate lasts three years; HELOCs, on the other hand, don't have such a grace period, and their rates move up and down with the prime rate.

Lenders commonly advise home buyers to get adjustable-rate mortgages if they plan to live in the house for less than three or five years. Similarly, most lenders would advise HELOCs for borrowers who expect to move within a few years, because HELOC rates will be lower for much of that time, so they'll save money in the short-to-medium run.

How will the money be used?

Besides the rate environment and your projected time in the home, there's another factor to consider: how the money will be used. If you're borrowing against your home's equity to consolidate credit card debts, it might be better to get a home equity loan. It pays you a lump sum and you have equal monthly payments for the life of the loan (often 15 years). The fixed payments apply some external discipline: If you start racking up credit card debt again, you'll notice quickly.

A HELOC differs in that it gives you a revolving line of credit, like a credit card. For the first few years, a HELOC's minimum payments allow you to pay only the interest and not the principal. That gives you room to get back into debt trouble if you lack willpower.