Could the mismatch between short-term and long-term interest rates change the way millions of Americans tap their home equity for remodeling, college tuition, autos and other big-ticket expenses?
Market forces certainly are pushing consumers in that direction, and there is evidence the shift is already underway. You can refinance into a conforming 30-year fixed-rate mortgage and take substantial cash out for 5.75 percent with little or no closing costs. But a new home-equity credit line, pegged at prime plus 1 percent, would run you 7.5 percent to start. Worse yet, it is highly likely to get more expensive in the coming months under Federal Reserve Board monetary policies. Even equity lines at prime plus zero don't cut it.
The prime bank rate is at 6.5 percent and it, too, is likely to jump by another quarter to half a percentage point by the end of 2005. Long-term rates, by contrast, are beyond the Fed's control; they are affected instead by the cost of 10-year bonds in global capital markets. Though long-term rates could rise modestly by year's end, according to some economic forecasting models, the gap between short-term home equity rates and long-term prime mortgage rates is likely to persist or even widen.
Which leads me to this practical question: If you need cash for a big expenditure, should you take out a floating-rate home-equity line and risk steadily rising monthly payments? Or should you lock in today's cheaper long-term money by going for a cash-out refinance? If you already have a large equity line that is beginning to eat you up with payment increases, should you dump it and opt for a cash-out refinancing in the high 5 percent range?
There are no pat answers here; every homeowner's situation calls for individual analysis. But signs are emerging that growing numbers of people are looking again to long-term rates and cash-out refinancings. Mortgage investment giant Freddie Mac reports that cash-out refinancings last quarter hit their highest level since late 2000. Fully 74 percent of all refinancings involved borrowers increasing their principal balances by 5 percent or more, said Amy Crews Cutts, deputy chief economist at Freddie Mac.
Though some cash-out transactions add as little as 5 percent to the principal, many yield borrowers far more -- 20 percent, even 50 percent. The owner of a $400,000 house with a mortgage balance of $100,000 can readily refinance, cash out $200,000 and still have a comfortable 25 percent equity cushion in the property. The extra $200,000 is tax-free, and can be spent on whatever the owners choose.
Why the sudden switch to cash-outs? Cutts believes that growing numbers of consumers see today's long-term rates "as their last chance" to borrow at close to historically low costs.
"People know rates are going to go up and they want to get in and lock it up while money is still cheap," she said.
Bankers also are seeing the first signs of a shift from floating-rate home-equity lines to cheaper fixed-rate 30-year or hybrid adjustables. Hybrids typically carry attractive fixed rates for five or seven years before morphing into mortgages with annual rate adjustments.
Kenneth R. Koranda, president of Mid America Bank of Clarendon Hills, Ill., a suburb of Chicago, said, "It's happening already and it's likely to continue if spreads between [home-equity lines] and 30-year and 5-1 hybrid adjustables widen."
Not all current home-equity credit-line borrowers are necessarily candidates for a transfer to a fixed-rate cash-out refinancing, however, Koranda said. People with relatively small equity-line balances haven't felt much of a pinch from the 21/4 percent short-term rate increases during the past year. Other borrowers may like the convenience of credit lines -- tapping their equity quickly when they need it, rather than pulling out large chunks through refinancings that might entail closing costs.
Homeowners who used 80-10-10 piggyback first and second liens to avoid paying mortgage insurance also may not have the flexibility to bail out into a fixed-rate refinancing unless their property value has appreciated significantly.
But for others, Koranda said, the short-term versus long-term rate equation right now tilts strongly toward fixed-rate cash-out refinancings. He just hopes his equity-line customers who have short-term rate jitters will stick with his bank and refinance into "our very attractive fixed-rate alternatives."
Kenneth R. Harney's e-mail address is KenHarney@earthlink.net.