Rising Interest Rates Taking a Toll

thePoint
December 28, 2005

A few years ago, Jay Gravelyn was in a 30-year mortgage with an appealing fixed rate of 5.75%. But he was in the mortgage business at the time, and he saw an opportunity.

He took out a line of credit on his home at 3.5% with an annual fee and paid off his $135,000 balance and car loan.

"I just did the math," Gravelyn, 38, tells The Grand Rapids Press. "I was looking at it, and I thought: Holy moly, I can go down to 3.5% with no closing costs." It was a no-brainer.

Gravelyn joined the swarms of people cashing in their equity for home-equity loans or lines of credit when the prime rate—to which equity loans and lines of credit are tied—was hovering around 4%.

While he used the cash to pay off his mortgage at a lower rate, many people use it to consolidate debt, buy cars, pay for college, or tackle a home-renovation project.

But the days of the 4% prime are over. Try 6.75% instead.

Homeowners nationwide have seen their home-equity borrowing costs rise since the Federal Reserve began raising short-term interest rates more than a year ago. Those loans don't look as attractive as they did a few years ago, and many borrowers want to pay them off.

"It's a great time to refinance them," says Russ Daniel, senior vice president at Independent Bank. "The interest that people are paying has gone up, so their monthly payments are higher for having the same amount of debt."

The rising rates also mean consumers might have to rein in their spending—HELOCs have been a major source of funding for big-ticket expenditures.

That reduced spending could have broader implications for the economy, which has grown in part due to consumer spending fueled by record low borrowing costs.

The rising interest rates and associated costs are catching consumers off guard. As borrowing money became easy and inexpensive, rates of consumer saving plummeted.

"We're at 45-year lows in interest rates, and our environment prevailed for almost three years," says Greg McBride, senior financial analyst with Bankrate.com. "Now, it's face-the-music time for homeowners and consumers with variable rate debt."

Lenders, such as Joel Van Elderen of Heartwell Mortgage, are getting calls from people with HELOCs looking for ways to pay them off.

Bob Hein, a mortgage loan officer with Priority Mortgage, says he has had "a ton of inquiries" regarding paying off HELOCs. "But it poses a real problem," he adds. "Some people don't have enough equity to blanket the mortgage into a new one.”

Cascading Effect

The series of Fed rate hikes that began last summer have prompted financial institutions to increase their prime rates, which serve as a benchmark for a variety of loans, including HELOCs.

"This has been a long, sustained rise," says Amy Crews Cutts, deputy chief economist at Freddie Mac.

McBride said the Fed isn't done. He predicts prime will reach 7.25% by the end of the year. The last time the prime rate averaged about 7% was June 2001.

"The Fed is raising interest rates on a very regular schedule," he says. "You're likely to see more."

Many consumers are refinancing their first-lien mortgages and withdrawing cash, so-called cash-out refinancing, to pay down HELOCs that can range in size from $25,000 to $40,000. Cash-out refinancings rose in the second quarter of this year to levels not seen since the fourth quarter of 2000, according to Freddie Mac.

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 were a big driver.

"Interest rates are going up and HELOCs are looking relatively ugly right now," she concludes. 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.

This article was prepared by the staff at the Point for Credit Union Research and Advice and is published online at http://thepoint.cuna.org/. Reprinted with permission.