(Final part of a two-part series. See Part 1: Real estate loan may lack payment protection.)

Last week’s column pointed out that home equity loans (HELs) are very attractively priced in the current market. This is why many borrowers are tempted to refinance out of their existing fixed-rate mortgage (FRM) or adjustable-rate mortgage (ARM) into a HEL. I also warned that HELs are the riskiest of all ARMs because they don’t have the protections against severe payment shock – a sharp and sudden increase in the mortgage payment – that other ARMs have.

Whether the risk is worth taking in any particular case depends primarily on four factors. The first is the rates at which you can borrow. The larger the spread between the initial rate on the HEL and the rate on the alternative mortgage, the stronger the case for the HEL.

The second factor is how long you expect to have your mortgage. Since the HEL rate is lower at the beginning but could be higher later on, the shorter the period you have the new mortgage, the stronger the case for the HEL.

The third factor is how rapidly you expect to pay down the balance during the period you have the mortgage. Making larger payments in the early years reduces the balances on which the potentially higher rates on the HEL in later years are applied. The higher the payments you expect to make in the early years, the stronger the case for the HEL.

The fourth, and by far the most difficult factor to assess, is how far and how fast HEL rates might increase in the future. You don’t know this any more than I do, so what we have to do is make a plausible assumption. My working assumption is that the prime rate to which the HEL rate is tied may increase by 1 percent a year for 5 consecutive years.

I’ll illustrate with Tom Prudence, who could get a HEL at the prime rate of 4 percent, and a 30-year FRM at 6.28 percent in early June 2004. He is deciding between the two. Tom elects to use my assumption about future HEL rates, which means that the prime rate is assumed to rise from 4 percent to 9 percent over 5 years.

Given this rate assumption, we know that if Tom holds the loan only for three years, he will come out ahead with the HEL because the HEL rate will be below the FRM rate for the first three years. In year 4, however, the HEL rate will hit 7 percent and start to turn it around. Break-even occurs at about the 57th month. If he holds the mortgage longer than that, his total costs – the sum of payments plus lost interest less reduction in the loan balance – will be lower on the FRM than on the HEL.

If Tom makes extra payments in the early years, he lengthens the break-even period. For example, if he makes a payment calculated at 6.625 percent during years 1, 2 and 3, he extends break-even to five years. To extend it to six and seven years, he has to make payments calculated at 9.15 percent and 10 percent, respectively.

HELs usually allow the borrower to pay interest only for the first 10 years. For reasons explained above, this option is counter-productive for a borrower looking to save money relative to a higher-rate FRM. The borrower who pays interest only will have the shortest possible break-even period.

Borrowers with very tight budgets and little in the way of a financial reserve have an additional reason for avoiding interest-only on a HEL. If interest rates spike in the future, the IO payment jumps the most. For example, if the HEL rate stays at 4 percent for five years, then jumps suddenly to 9 percent, the borrower paying interest plus principal (the “fully amortizing payment”) will face a 59 percent increase in payment. But the increase for the borrower paying interest only will be 225 percent.

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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