(First of 2 articles)

“I have a first mortgage for $161K at 7.125 percent, a second for $40K at 7.5 percent, and $50K of credit card debt at 13 percent to 19 percent. We could refinance the first and second mortgages into a fixed-rate loan at 6.25 percent. But we could also refinance them into a home equity loan at 4 percent (prime rate plus zero) and no cost, and with interest-only payments for 10 years. The sharp reduction in mortgage payments would allow us, at long last, to pay down our credit card debt rapidly. It seems like a dream come true. What am I overlooking?”

You are overlooking the risk of a sharp increase in the prime rate, which could quickly turn your dream into a nightmare. Some borrowers are positioned to take this risk, but you aren’t one of them.

In recent weeks I have been deluged with questions about refinancing into a home equity loan (HEL). Traditionally viewed as a second mortgage placed atop a first mortgage, the new game in town is to replace the first mortgage (and an existing second mortgage if there is one) with an HEL first mortgage.

This has been driven at least partly by recent interest rate changes. Rates on 30-year fixed-rate mortgages in early June 2004 were about 1 percent higher than they were one year earlier, but the prime rate hadn’t budged. This gave HELs, which are priced at the prime rate plus a margin, the appearance of a bargain. Furthermore, in many cases including yours, HEL transaction costs are very low or zero. That’s the good news.

The bad news is that HELs are really adjustable-rate mortgages (ARMs) without the protections that other ARMs provide against payment shock. Other ARMs fix the rate for some period at the front end – the period can be as short as a month or as long as 10 years. On HELs, there is no initial fixed-rate period. If the prime rate changes on Monday, the rate paid by the borrower will change on Tuesday. HELs accrue interest daily.

Conventional ARMs, furthermore, reduce the size of any single increase in the mortgage payment with caps on the size of interest rate increases or payment increases. HELs have no adjustment caps.

Conventional ARMs also have maximum interest rates that are usually 5 percent to 8 percent above the initial rate. On HELs the maximum rate is generally 14 percent to 17 percent above the initial rate.

For all these reasons, HELs are the riskiest ARMs out there.

It is sometimes argued that the prime rate used by HELs is more stable than the rate indexes used by other ARMs, an argument that seems to be supported by the fact that the rate hasn’t changed since it hit 4 percent on June 27, 2003. But don’t be fooled by this very recent history. During the five-year period of Jan. 1976-Jan. 1981, the prime rate changed 84 times in going from 7 percent to 20 percent. In 1978 alone, it increased 15 times. In 2001, it declined 11 times.

Indeed, the recent stability of the prime rate in the face of rising rates on other mortgages signals greater, not less, risk for the HEL borrower. The prime hit 4 percent in the last week of June 2003, when Freddie Mac reported an average rate of 5.24 percent on 30-year fixed-rate mortgages. One year later, Freddie reported an average of 6.28 percent and the prime is still 4 percent. That makes it more likely than not that the next change in the prime rate will be an increase.

It is foolhardy to take a risk that will land you in the poor house – or without any house at all – if it doesn’t pan out. Taking the HEL and paying interest-only is the riskiest thing you can do because future rate increases have maximum impact on your mortgage payment. I recommend HELs as the first mortgage only for borrowers who plan to make extra payments rather than minimum payments, and expect to be out of their houses within seven years. This will be explained further in next week’s column.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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