Q: I just got a letter from my mortgage lender offering me a 6.5 percent fixed interest rate on my home equity line of credit balance, which is right around $100,000 and is the only debt I have on my $500,000 home. My family and friends think that’s a great rate, and are urging me to fix it.
My hesitance is that my current interest rate on that line is in the 2 percent range and it has never been higher than about 5 percent in the several years I’ve had the loan.
A: Author Erica Jong once said, "Advice is what we ask for when we already know the answer but wish we didn’t." Reread your question and you’ll see what I mean.
There’s always the fear that if you don’t take advice you’ve been given by different people, you’ll be making a mistake. Or perhaps you’re wondering if there’s something you’re not missing that everyone around you knows — that’s also a very common human psychological tic — to assume that the popular opinion is necessarily correct. But if we’ve learned nothing from the last few years, we should have learned that the popular course of action — especially when it comes to real estate, mortgage and personal financial decision-making — is very often, in fact, not the smart course of action for everyone.
But let’s get down to why you’re being given this advice, and how to really approach making this decision. Some folks would just say that it’s a no-brainer: Keep your loan.
Others always prefer fixed to adjustable, but in your situation, to "fix" your home equity line of credit (HELOC) would be to sign up for a more predictable, but almost certainly higher monthly payment than what you’re currently paying. That just does not make good financial sense, in my opinion.
There are a number of reasons why your friends and family are advising you to do this, though. And there are also a number of ways to systematically assess the risk of continuing with an unpredictable interest rate and payment on this loan.
Need-to-Knows and Action Plan
Human nature is to make verbal shortcuts, which often result in corresponding mental shortcuts. Since the crash of the subprime mortgage market, many people made the verbal shortcut of referring to subprime loans as adjustable-rate mortgages (ARMs). While it’s true that many predatory and/or unwise subprime mortgages were, in fact, ARMs, the worst and most foreclosure-prone of these had several dramatically bad characteristics to them, which had little or nothing to do with the fact that they had an adjustable interest rate. …CONTINUED
In fact, the undesirable characteristics of some subprime mortgages that rendered them likely to end up in foreclosure were, primarily, the failure of their lenders to require any income documentation and the failure of their lenders to require any repayment toward principal and/or interest during an introductory period (the latter in the case of the option ARM, in which balances actually grow over time if the minimum payment option is consistently made).
The distinctions between these "broken" ARMs and your HELOC weigh against electing to fix your ARM. Your HELOC almost certainly requires payment toward both principal and interest every month, and did from the very start of the loan. That means that when your rate adjusts, your payment will adjust only incrementally, and it doesn’t ever stand to double or triple the entire payment amount (like an interest-only or option ARM payment adjusts after the introductory period elapses).
Additionally, the low balance of your second is in stark contrast to many whose ARMs were their first mortgages, with balances of several hundred thousand dollars and much more (in some cases).
You are in a position to evaluate the risk the adjustability of your HELOC’s interest rate poses, and there are very likely some features built into your loan that help manage that risk. Dig up your loan documents for the HELOC and look for your interest-rate cap and adjustability caps. Almost every HELOC that was originated within recent memory has a cap that sets a top limit on how high your interest rate can ever go.
Also, they almost all have a cap on how much of an interest-rate increase your loan can ever adjust in a given time period, usually a year.
It’s also important that you know and keep an occasional eye on the rate index on which your HELOC’s rate is based. This will also be in your loan docs. Some indices move faster than others, but almost none of them are going to skyrocket upwards in less time than you could refinance your HELOC.
Most people take refuge in knowing their caps, and knowing that they can revisit the idea of fixing these types of ARMs if and when they ever do break, so to speak, by adjusting beyond their comfort level. (This is especially true for you — since you do have a great deal of home equity, fixing that HELOC should not be a problem if and when you do ever decide to do it.)
Unlike the ARMs that have infiltrated the national consciousness, your ARM is not broken. You know the old saying about fixing things that aren’t broken, right? Don’t.
Tara-Nicholle Nelson is author of "The Savvy Woman’s Homebuying Handbook" and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Ask her a real estate question online or visit her Web site, www.rethinkrealestate.com.
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