Q: I know that first mortgage rates are really low, but why are home equity loan and home equity line rates so high compared to them?
A: Welcome to the world of "junior liens," also called second mortgages. There are several reasons why these products have high interest rates.
Unlike most first mortgages which are sold to Fannie Mae or Freddie Mac or backed by the FHA, second liens are usually held by the mortgage lender who originates the loan. This means that the lender who makes the loan gets all of the costs of servicing the loan and all of the risks associated with it.
Being in the second position behind a homeowner's first mortgage can leave the home equity lender exposed to loss. In times of hardship, you might stop making payments on your second lien even though you continue to make payments to your first mortgage lender. This can make it very difficult for the second lien lender to recover any money you borrowed, as the first lien holder would need to agree to allow foreclosure proceedings to take place for this to occur.
Even then, if you should default on your loan, and the home goes through foreclosure, there may not be any money left after the first mortgage lender (holder of the primary lien) gets paid off. This was especially the case in the years after the last home price collapse -- many second-lien-position lenders could not recover money they lent.
So the lender who makes you a home equity loan or line of credit faces considerable risk and possibly little reward. Most equity loans and lines have small loan amounts compared to first mortgages, and are usually written in terms of 10 or 15 years. Relatively small loan amounts and relatively short repayment periods mean relatively little interest income is being made by the lender, so the interest rates charged to you must be enough to "interest" the lender to lend money to you in the first place.
Even though they may seem high, fixed home equity rates are actually very competitive relative to other forms of borrowing, such as personal loans or advances taken on credit cards. Home equity lines of credit are usually governed by the Prime Rate and have been increasing along with that indicator, which is highly sensitive to policy changes made by the Federal Reserve. That said, while relatively high today, a HELOC may see its interest rate decline in the future, too, so your interest cost may actually decline over time.
Read more about how home equity loans and HELOCs are priced.
