NEW YORK (Money Magazine) - When customers approach a lending officer at Pittsburgh-based PNC Bank to refinance their mortgage, they're offered a menu of choices. One of them is not a refi at all.
At PNC -- and, we hear, at many other banks all across the country -- homeowners are being encouraged to take out a home-equity line of credit (HELOC) and use that stream of cash to pay off their first loan. That's one reason that outstanding HELOC debt has climbed from $163 billion in 1999 to $359 billion in 2002.
It sounds like a tempting offer.
According to HSH.com, which publishes mortgage-rate information, 15-year fixed-rate loans are now going for 5 percent. You can get a HELOC at prime, currently 4.25 percent, in just about any market in the United States.
Moreover, on a refi you'd pay an average of half a point -- or 0.5 percent of the amount of the loan -- in closing costs and another half a point in legal fees and appraisals. Closing a HELOC at PNC runs just $21.
"It makes sense," says Mike Moll, director of marketing at PNC. He not only swapped his own 6.875 percent, 30-year fixed-rate mortgage for a HELOC at 4.25 percent but also sold his brother and brother-in-law the same deal.
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Is Moll right? He's definitely onto something, says George Yacik of SMR Research, which maintains data on the HELOC market.
"For people who have $90,000 in mortgage debt and a $1,000,000 credit line," Yacik notes, "writing themselves a check is equivalent to a quick refi -- a free refi."
But even if it's fast and cheap, it may not be smart. The reason: A HELOC is an adjustable-rate loan.
"The question you need to ask yourself is, why would a bank be pitching you this product at this time?" says HSH's Keith Gumbinger. "The obvious answer is that bankers believe rates will rise in the future. Getting you out of a fixed loan and into a variable one helps ensure profitability on your account."
Moreover, he notes, when rates rise, they can do so very quickly. The period of interest-rate hikes we experienced beginning in 1998 saw rates rise two points over a year and a half. A jump like that would make today's 5 percent fixed-rate mortgage look downright cheap.
So what sort of customers does a home-equity arbitrage like this make sense for? Gumbinger ran some scenarios to see. Here's one.
Let's assume you bought a home 10 years ago, taking out a $300,000, 15-year fixed-rate loan at 7 percent, and you've never refinanced. Your monthly payment on that loan is $2,696. Today you have an outstanding balance of $136,200, of which $26,000 is interest.
Refinance the balance into a new 15-year mortgage at 4.98 percent, and your monthly payment slides precipitously to $1,075. But if you take the full 15-year period to repay the loan, you end up more than doubling the total interest you pay, to $56,000.
What if you instead take the HELOC with a 20-year term at 4.25 percent? If rates stay low, you're golden. But if they rise 1 percent a year until they hit 7.5 percent -- the average prime rate over the past decade -- your monthly payment climbs from $843 in the first year to $1,073 in years five through 20. Over the 20 years, the interest will total $114,000.
There is a way to save real money in this situation: prepay like crazy.
If you continue to pay at your old rate on the new 15-year mortgage, you get out in 56 months and save roughly $6,500, after $2,600 in closing costs. If you opt for a HELOC instead -- assuming you get one with no prepayment penalties -- the absence of closing costs and the lower starting rate would about double your savings, even if rates go up 1 percent each year.
Is it worth it? It may well be -- but only if you have the stick-to-itiveness to watch rates like a hawk and quickly lock in a new fixed-rate loan if they start to rise. PNC's Moll thinks he can do that. Then again, he works in a bank.
