Q: We took out a home equity line of credit a couple years ago and thought we were getting a great deal with an interest rate set to the Prime Rate. Now the Prime Rate is all the way down to 3.25 percent, which is great. But we are very concerned that the Prime Rate will shoot up soon because of high inflation caused by all of the government spending this year. We’d like to refinance our first mortgage to lock in a low fixed rate mortgage and pay off that equity line, but our home value has fallen so much that we owe a little more than the combined balances of our first mortgage and home equity loan. So we are stuck with the home equity loan. Should we try to pay the balance down while the interest rate is low?
A: You are in a similar situation to many people who purchased homes or refinanced their mortgages near the peak of the housing market in 2006 and 2007.
Depending on your neighborhood, your home may be worth anywhere from 15-30 percent less than it was worth at the height of the housing boom. That wipes out the equity that could have been used to refinance your mortgage.
Here’s an example:
Let’s say your home was worth $500,000 at the peak of the housing market in 2007. At that time, you had a $300,000 first mortgage and you added a $100,000 home equity line of credit. That would have been a total Loan-To-Value (LTV) ratio of 80 percent which is fairly conservative. In other words, the total debt owed against the home (first mortgage + equity line) was equal to 80 percent of the home’s fair market value.
If home values had remained the steady, you could have refinanced the first mortgage to pay off the home equity line and still have a total LTV of 80 percent.
But as we all know too well, home values did not remain at 2007 levels. Let’s assume that the value of the home in the example above dropped 20 percent so that it is now worth only $400,000. That means the combined balances of the first mortgage and equity line ($300K + $100K) would equal 100 percent of the home’s current market value, which is a 100 percent LTV. Keep in mind that to keep this example simple, I am ignoring the small principal reduction of the two year’s worth of loan payments.
No bank or mortgage company will do a 100 percent LTV refinance loan these days – unless you qualify for one of the Fannie Mae or Freddie Mac bailout programs, which is beyond the scope of this column. In brief, the bailout programs allow you to refinance your first mortgage only. You cannot refinance your second mortgage to lock in a fixed rate on your home equity line of credit.
So, as you said, you are now “stuck” with the home equity loan until you sell the home. It might make sense to pay down the balance of the home equity loan while the interest rate is low so that you don’t have to worry about handling the payments if interest rates skyrocket in the future. But it depends on how much cash reserves you have in the bank.
In the “old days” of three or four years ago, you could pay down your home equity line and then borrow the money back again if you needed extra cash in the future. But these days, banks are freezing equity lines and not allowing homeowners to borrow any more money with them. So if you paid $10,000 to reduce the principal balance of your home equity line and the bank froze your line at the new, lower balance you could never get that money back until you sold your home.
If you had $50,000 in a savings account to provide a safety net in case of a job loss or economic problems caused by the recession, that may not be a problem. But if the $10,000 that you used to pay down the home equity line was all the money you had in the bank, you would be in big trouble in a financial emergency.
In these uncertain economic times, I am a big believer in keeping lots of cash in the bank. Sure it might not seem to make sense to pay interest on your loans when you are earning only one percent or less in a bank savings account, but you can’t borrow money as easily as you could in the past. The easy credit days are over. Cash is king, and the more you have the better off you will be if you run into financial difficulties.
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