Dennis' Mortgage Blog

Question of the week:  I have a Home Equity Line with a high balance and a low interest rate, what advice do you have for me?

Answer:  This week’s question applies to current homeowners, but future homeowners may want to read in case they find some information to assist them with debt management.  Home Equity Lines of Credit, or HELOCs, are prevalent throughout the United States, and very prevalent through Southern California.  First a brief history of why, if you are not interested in the history and just want the answer skip below to now the answer::

Around 2000 a major national lender rolled out a very attractive HELOC product that would go to 90% loan to value (refresher: loan to value, or LTV, total amount of loans as percentage of value of home; if 90% LTV on property worth $500,000 the mortgage(s) total on home equals $450,000).  Prior to this product being introduced to the market and so accessible to home buyers anyone purchasing a home with 10% had to have mortgage insurance, or PMI (the “P” is for private, as opposed to the mortgage insurance on government insured loans such as VA or FHA); unless the seller of their future home was will to carry back a second trust deed of at least 10% of the purchase price—which very few sellers were, or are, willing to do.  So the new product allowed us to have homebuyers purchase homes with “80-10-10” financing and avoid mortgage insurance; doing the math the total monthly payment was lower and the tax deduction was higher (this was before limited deductions for mortgage insurance became part of the tax code).

As the popularity of the HELOCs as tools for homebuyers became more popular other lenders jumped into the market with their own HELOC products.  As the popularity grew and home values climbed, and pressure from Congress grew on Fannie Mae and Freddie Mac to increase homeownership opportunities, the combination expanded the use of HELOCs.  Lenders began offering HELOCs to 95% LTV and as those were snapped up lenders began offering fixed rate second trust deeds and HELOCs to 100% LTV.  Fannie and Freddie both had products for buyers to use “80/20” financing—essentially 100% financing—using HELOCs as part of the financing. 

Outside of the purchase arena lenders were allowing HELOCs to be added to existing home owners debt structure, some lenders going as high as 100%, others capping at 90%.  With the boom in home values many homeowners took advantage of their higher home values to access their equity with HELOCs.  As a result of loosening credit guidelines from Fannie and Freddie on their mortgage products, and aggressive guidelines on many HELOC products, the number of homes with a HELOC recorded against them grew exponentially from 2003 through 2007.

What is a HELOC? It is a line of credit that operates very similarly to a credit card.  A homeowner is given a maximum credit limit and may access up to that amount of money and pays interest on the outstanding balance; whatever is not accessed up to the maximum limit is available for future borrowing.  Because the outstanding balance can go up and down as equity is accessed and then paid back the rate of interest on the HELOC is also adjustable, almost always adjusting with the Prime Rate.  Homeowner Bob has a HELOC with $100,000 as the maximum limit and it has a rate of Prime + 0, Bob has pulled out $35,000 to remodel a bathroom in his home.  Since Prime is currently 3.25% the interest Bob owes on the debt for the current month is (35,000 x 0.0325)/12   {Balance times rate divided by twelve for monthly payment) = $94.79 plus and principal he chooses to pay.  Pretty cheap, eh?

Okay now what if Bob owes $235,000?  The monthly payment is now $636.46 for the interest, still relatively cheap for having borrowed over one-quarter of a million dollars.  Keep in mind on other factor, chances are pretty high that because of declining home prices Bob’s original HELOC probably had an available balance of $325,000 and the lender reduced the available balance to his current balance. So with the interest rate at 3.25% what should Bob do?  That is the question I still have not answered.

Now The Answer!  Bob, or anyone with a high balance on their HELOC, has a current interest rate of Prime, for some holders of HELOCs their rate is Prime Plus with a margin added to the rate, either way the interest rate is extremely low.  Using Prime as the guide here is a chart showing the history of the Prime Rate from 1994 to present:

The red line indicates the approximate average rate for the past fourteen years.  As you can see in the past eight years we have spent more time below the average than above—but just two years ago Prime was as high as 8.25%--so what are we to expect for the future?  Let’s take a look at time below the line.  Prime hit a high of 9.25% before being adjust down in May 2000.  As the economy at that time began to slow and a recession set in following the economic growth and expansion that began in the middle of the Clinton Presidency, the Fed began to cut rates.  As the recession continued into the beginning of the Bush Presidency the Fed was pretty steady in rate cuts, until 9/11 when it became more aggressive.  Bottoming out in June of 2003 when it became apparent that economic growth was upon us, the Fed began consistent and incremental rate increases to allow for continued economic growth; as you can see the line going up is much flatter than the line going down before the increases started.  Peaking at 8.25% in June 2006 the Fed, seeing a slowing of growth in the economy began to cut the Prime rate to sustain the growth as long as possible.  As the credit crisis became apparent at the very end of 2007 the Fed went through some very aggressive rate cuts in early 2008 and eventually we landed where we are today in December 2008 at 3.25%. 

Each of the rates cycles bottomed out when our economic recessions bottom out, each of our rate cycles cap out when our economic recovery and growth caps out and the next cycle begins.  So with this knowledge, when will our current economic cycle bottom out? When it does bottom out and recovery and growth begin how fast will it occur?  How long will it last?  The answer to these questions will determine how high and how fast and how long the Prime Rate will climb.

Let’s go back to Bob with his $235,000 HELOC balance at Prime, currently paying $636.46 per month in interest.  If Prime were at its fourteen year average, 6.8%, he would be paying $1331.67 per month, more than double his current payment; if Prime were at its most recent 36 month high of 8.25% Bob would be paying $1615.63 per month just in interest.

As we can see from the chart Prime is at a historic low, which means that it will have to rise.  Knowing that the rate will rise, and therefore your payment on the HELOC you have, it is advisable to pay down as much principal as you can to lower the balance so when the Prime rate does increase your payment increases are lower than they will be if you just make minimum interest payments.  Leverage your monthly debt payments to pay down as much debt as you can as fast as possible, rates are going to rise and the more you are able to pay down/off today before they do rise the better your financial future will be.

My suggestion is keep a list of your debt obligations and their monthly minimum payments and interest rates.  Using this chart create a plan that will allow you to pay off one debt at a time until all your debt is paid off—saving your biggest debt, your mortgage for last since it is tax deductible.  Include in the list aggressive pay down of your HELOC by using as the monthly payment not the minimum monthly payment but what the monthly payment would be if Prime was at its recent high of 8.25%, then as the Prime Rate increases your monthly budget is already adjusted for the increase.  As you pay off one debt obligation transfer the payment to the next one until you are debt free and are able to concentrate all of your monthly debt budget on your HELOC.  It takes discipline but if you are committed and dedicated you can create a plan that will rid you of your revolving debt obligations in a relatively short period of time.

For a look at how rates are connected to economic cycles and inflation see my post “Money” at my “other” blog site.

I will keep this link on my “Question of the Week” section to assist new homeowners:

IRS Form 5405 for First Time Buyer Tax Credit for those eligible

Have a question for me?  Ask me!   

What a crazy week.  After positive gains in Mortgage Backed Securities (MBS) on Thursday and Friday of last week we started this week very positive as well. Keeping in mind “higher” and “climbing” are good news as I am referring to bond prices, which means rates dropping since mortgage/bond rates drop when the prices on the securities and bonds rise.  Climbing through the 200 day moving average on Monday, climbing even higher on Tuesday, Fannie MBS broke through the 25 day moving average early Wednesday morning Pacific.  Then as quick as they climbed on Wednesday the dropped, and dropped quickly.  Sliding through the afternoon we closed below the closing price on Tuesday.  Thursday opened negative and never saw positive territory racing to and then through the 200 day moving average.  Today bond holders to a break from selling and about mid-morning began buying again.  As a result we end the day and the week where we closed last Friday—no change. 

Most of the trading was influenced by economic news, no surprise, which caused some of the positive gains.  What led to the very fast sell off Wednesday and through Thursday was the news that the Treasury will be auctioning off $150 billion in Treasury notes next week.  Creating that much more supply depressed prices on all the bond markets leading to the drop in prices and climb in rates.

One factor I am keeping my eye on.  Earlier this year the Fed committed to buying huge amounts (that is a very technical term that those of us with degrees in economics like to throw around, “huge amounts”) of Fannie/Freddie mortgage backed securities.  And for much of the year, as can be seen by the chart, their efforts kept rates relatively flat and stable.  So flat and stable in fact that towards from March to---let’s see if we can find a date….looks like our bottom is currently May 15—from March to May 15^th rates attracted a very large number of applications in the mortgage industry.  So many that April saw the most applications taken since July 2003.  The volume was so great that it outpaced the ability of the Fed to purchase MBS thereby allowing prices to drop below what the Fed desired—over supply always drops prices.

Now applications have simmered back down to more manageable levels; levels that can be purchased adequately by the Fed commitment.  Because of this leveling of supply that is more in line with the Fed’s purchasing power we may (I am tempted to say should but am not ready yet), we may see rates stabilizing near current levels.  We shall see.

Rates flat this week—With the exception of an adjustment in the FHA-Jumbo rates we are flat from last Friday.

FIXED RATE MORTGAGES AT COST OF 1 POINT*

30 year conventional  5.375%                           FLAT

30 year conforming-jumbo 5.875%                   FLAT

30 year FHA    5.5%                            FLAT

30 year FHA jumbo 6.125%                            DOWN .125%

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, and period rate is locked (i.e 45 days instead of 30 days).

Please note that rates quoted are based on average of several lenders for a purchase transaction with 20% down payment and a minimum FICO score of 740; APR is not quoted as it is dependent upon specific loan amounts, lenders and services selected.  Numbers provided are for comparative purposes only.

Yesterday I attended a high school graduation for the first time since my own in 1980.  What a treat to hear the young speakers encouraging their classmates and the enthusiasm of the families as their kids were announced.  Their hopes and dreams do not seem to differ much more than my own when I was at that awkward period of my life between childhood and independent adult.  To the special graduates in our lives, for Leslie and I specifically Jacqueline, Tori, Tim and Chad, congratulations!  As you move into the next four years of your lives know that you will be challenged and doubted and encouraged and at times deflated.  Know that your parents were as well and what served them best is timeless and will serve you best as well:  act with integrity, value yourself and your values, require of your friends what you require of yourself and remember the character you display now will follow you so have character and show it.  And know that whether you need it or not, a call home to check in once a week or so will keep your compass pointed in the proper direction…and make Mom really happy.

Once last personal note.  Thanks Dad, I love you, Happy Father’s Day

Have a great weekend everyone, Happy Dad’s Day to all the Dad’s (and the Mom’s who frequently fill part of the role for us!),

Dennis

Remember this update is posted weekly on My Blog at www.DennisCSmith.com ; feel free to forward the link to family and friends who may be interested in past commentaries. 

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