Take a look at the current BankingMyWay rates survey, and you’ll see something odd: during the past week, all the mortgage rates have gone down and all the home equity rates have gone up. And those home equity rates are a lot higher, all more than 8% or 9%, while the highest mortgage rate, for the 30-year fixed-rate loan, averages about 5.2%.
Why are home equity rates so much higher when both loans use the home as collateral?
Mainly because the home equity lender stands in line behind the mortgage lender, making it riskier to issue home equity loans. If the homeowner defaults, the mortgage lender forecloses on the property to recover the outstanding debt. The home equity lender recovers what it is owed only if there’s something left over. These days, many homes are worth less than the mortgage balance, so the home equity lender may get nothing.
Despite rates of more than 8%, home equity installment loans, which charge a fixed rate for the loan’s life, can be a good way to pay for a renovation or college education. Most investors can deduct home-equity interest payments on their federal taxes. So an 8% loan costs just 6% after taxes, assuming a 25% tax bracket.
That’s a lot better than paying 18% on a credit card, especially as card interest is not tax deductible.
The reason: HELOCs are floating-rate loans that typically adjust every month or so. The lender can charge less because it knows it can always charge enough to make a profit even if prevailing interest rates rise. Lenders making home-equity installment loans must charge more because their fixed rate must be high enough to offset the risk of prevailing rates rising before the loan is paid off.
HELOCs are “revolving-credit” loans, which means they provide a borrowing limit. Below that limit you borrow only what you want to, just as you do with a credit card. Home equity installment loans usually come in a lump sum, like a mortgage or car loan.