Home Equity Borrowing Begins to Lose Its Luster

For Kim and James Merly, the home equity line of credit came in handy -- it helped pay for their son’s college education, a car and renovations of two rental properties.

Recently, the Fairfield, Conn., couple noticed their interest rate had jumped to 6% from the 4% they paid in January 2004, when they first opened the account. They decided it was time to pay off the credit line.

Homeowners nationwide have seen their home equity borrowing costs rise since the Federal Reserve began raising interest rates more than a year ago. Many, like the Merlys, now want to pay off the loans, which no longer look as attractive as they did a few years ago.

The rising rates mean consumers may have to rein in their spending; home equity lines of credit have been a major source of funding for big-ticket items. That could in turn have broader implications for the economy, which has grown partly because of consumer spending amid record low borrowing costs.

“There has been a false sense of financial security many consumers have been living under” with low interest rates, said Chris Viale, of Cambridge Credit Counseling Corp.

“I love the home equity, but it’s got its pitfalls with the rates that go up and down. Basically, it is just a glorified credit card,” said Kim Merly, a part-time office administrator who manages two properties that she and her husband, a contractor, rent out.

Like credit card rates, home equity loan rates have risen over the last year, much to the chagrin of consumers whose savings rate has dropped as borrowing has become easy and cheap.

“That home equity was increasing over time. You keep looking [at the monthly statements] and you realize you want something different,” said John Ammatelli, a sales consultant for a surgical equipment company. He recently paid down a home equity line on his home in Kansas City, Mo.

Mortgage bankers like James B. Nutter Jr. of Kansas City have found more people are coming through his door looking for ways to pay off their home equity credit lines. “With the rising rate environment, they want to get rid of it,” he said.

Viale said many consumers have been dismayed by the steady rise in borrowing costs. “They are shocked by the increases [in monthly payments] they are getting,” said Viale, who recommends consumers cut back on spending, create working budgets and pay down debt.

When the Fed changes its monetary policy, it typically does so by tweaking the federal funds rate, the interest rate banks charge one another on overnight loans. The series of rate hikes by the Fed that began last summer have in turn prompted U.S. banks to increase their prime rates, which serve as the benchmark for a variety of loans including home equity lines of credit.

In the beginning of 2004, the prime rate was 4%; it now stands at 6.5%.

“This has been a long, sustained rise,” said Amy Crews Cutts, deputy chief economist at Freddie Mac. She believes the Fed may raise interest rates two more times by year-end, bringing that prime rate to 7%.

The last time the prime rate averaged about 7% was June 2001.

Many consumers like the Merlys are refinancing their first-lien mortgages and withdrawing cash, so-called cash-out refinancings, to pay down home equity lines of credit, often in the range of $25,000 to $40,000 but sometimes far more.

According to a study by Freddie Mac, cash-out refinancings rose in the second quarter to levels not seen since the fourth quarter of 2000.

Freddie Mac, one of the two federal agencies that help lenders get money for home loans on Wall Street, could not pin down how many cash-out refinancings were used to pay down home equity lines of credit. But Crews Cutts believes the rising rates for home equity lines were a big driver.

“Interest rates are going up.... Home equity lines of credit are looking relatively ugly right now,” she said.

Crews Cutts estimated consumers used cash-out refinancings to pay down $40 billion of home equity debt last year and may pay down another $40 billion this year.

The rise in borrowing costs can be particularly hard for many first-time buyers who used home equity lines of credit as part of what the housing industry calls piggyback loans. Unable to foot a 10% or 20% down payment, many bought homes with little or no money down by taking a first mortgage and one or two home equity lines, according to Mary Boudreau, owner of Penfield Financial, a Fairfield, Conn., mortgage broker.

“Consumers are looking for some certainty in their payments and the rate they are getting,” said Doreen Woo Ho, president of Wells Fargo & Co.’s consumer credit group. She estimates that in the first quarter of this year, U.S. consumers held about $940 billion of home equity debt.

For the Ammatellis, paying off the home equity line of credit and rolling it into their first mortgage helped them save close to $600 a month.

“We’re getting rid of credit card debt over the next few months,” John Ammatelli said.

And although it makes sense for some consumers to pay down home equity lines of credit, some may be surprised by additional costs that come with getting out of the interest-rate riptide. Many banks charge consumers if they prepay lines of credit before a set period of time, typically two or three years. So some consumers face costs of not one but two loans -- the home equity line of credit and the refinancing.

“Some people may end up paying two sets of closing costs,” Crews Cutts said.