If you have a home equity line of credit with a variable interest rate, you have until recently been enjoying some of the lowest interest rates in history. But variable-rate HELOCs are based on short-term interest rates such as the Prime Rate, and given inflation concerns, many are expecting those short-term rates to continue to increase. With inflation on the rise and threatening to stick around for a while, it might be time to replace your variable rate HELOC with a fixed rate mortgage. While rates are still pretty low, here are your options:
First, Check Your Home Equity or HELOC Loan Documents
Many variable-rate home equity loans have provisions for converting some or all of the outstanding balance to fixed rate loans at one or more points during the term of the mortgage. It generally costs little or nothing to exercise this provision. Your conversion rate is determined by a margin, which was specified by your lender when you obtained your loan, and the value of a published financial index. Know, however, that the conversion rate may be no bargain -- finding out what it is may just be your starting point.
You'll need to consider if converting all or a portion of your HELOC to a fixed rate brings value. Yes, you'll receive a fixed-rate, fixed-term and fully-amortizing loan, but it's not uncommon to see the interest rate for any converted fixed-rate portion to be several percentage points higher than the variable rate your HELOC current charges. If you convert to a fixed rate in order to preempt potential future increases in your monthly payment, you may actually have guaranteed increases in payment today.
If your current loan is not convertible or doesn't offer the option to break pieces off into fixed-rate, fixed-term portions, you'll need to check with your current lender to see what terms it's willing to offer you to convert your interest rate.
Then, See if You Can Do Better
You may have a few options for exchanging an adjustable rate for a fixed rate. In addition to the HELOC conversion, you can:
Refinance your HELOC to a fixed home equity loan. Keep in mind that refinancing your HELOC to a fixed-rate loan means you will no longer be able to tap it for emergency cash flow. If that's a concern, you might want to draw on it and place the proceeds in a savings account for easy access.
Refinance your HELOC to a new HELOC with better terms. Over time, it's likely that your home's value has increased while your mortgage debts have declined. This means a lower loan-to-value ratio for your debt, and a lower LTV may see you able to wrangle a lower margin compared to your existing HELOC, so even if a fixed-rate can't bring the savings you want, you can still help lower your current costs.
Wrap your second mortgage into a new fixed rate first mortgage. Factor in mortgage insurance when analyzing this option if your loan-to-value will exceed 80%. In addition, a new first mortgage can carry significant out-of-pocket closing costs, so you'll need to factor any costs of obtaining new credit into your calculation as well.
Verify Your Home Equity
If you're not certain how much equity you have in your home, you can get a working idea by checking home valuation sites or using HSH's Home Equity Calculator and Projector. To see what's been happening to home valuations in over 400 metropolitan areas across the country, HSH's Home Value Tracker can give you a good working sense of home value trends in your area. If you still have 20% to 25% home equity, you're in a good position to refinance your HELOC or wrap it into a new first mortgage.
Know Your Blended Rate
What's a blended mortgage rate? It's the rate you pay on all of your mortgage debt when you have a first and second mortgage. If trying to determine whether a new first mortgage would be better than keeping your current first mortgage and refinancing your second mortgage, you need to know your blended rate. It's easy to calculate:
Take the amount of your first mortgage and divide it by the total of your first and second mortgages. For example, if you have a $400,000 first mortgage and a $100,000 second mortgage, you divide $400,000 by $500,000. You get 0.8.
Multiply that number by the interest rate on your first mortgage. For example, if you're currently paying 6% on your first mortgage, that number (.06 * .8) is .048, or 4.8%.
Do the same thing with the second mortgage. In this case, you'd divide the $100,000 by $500,000 to get .2; multiply that by the interest rate on your potential second mortgage. If you are offered a fixed rate second at 8.5%, the result would be (.085 * .2) .017, or 1.7%.
Add the two weighted interest rates up (4.8% + 1.7%) to get a blended rate of 6.5%. So if you could get a no-cost refinance of both loans to a new first mortgage at 6%, wrapping the mortgages into a new loan might be an avenue to strongly consider.
What if You Can't Refinance?
If you don't have enough equity to refinance your HELOC or home equity loan, or if your credit rating has taken a hit and you don't qualify for the lowest mortgage rates, don't despair. Although interest rates are expected to rise or remain relatively high for a time, experts are often wrong when forecasting interest rates. The economy could take a turn for the worse, and markets and the Federal Reserve might engineer lower rates sooner than you think, so any rising-rate pain may turn out to be short-lived.
If you can't refinance your HELOC or convert it to a fixed interest rate that provides value, you can still accelerate your payments or make payments as though you have a new fixed-rate second mortgage. Use a mortgage calculator to see what your payment would be if you increased your interest rate a few points. Then, make that payment; the difference will go toward reducing your principal balance.
This can help you two ways: first, the lower your balance is when rates increase, the less your payment will rise. Second, accelerating your payoff means you'll have enough equity to refinance sooner rather than later, and even if you only do this for a year or two, in that time you may be able to make significant headway in reducing your outstanding balance.
Fixing the interest rate on all or a portion of your home equity line of credit is probably best done when rates are low, but there can still be reasons to make the change even if rates aren't at rock bottom. Certainty of payment -- and a known period for repaying your debt -- can help you to more effectively plan your future finances. For some, that's where the value of the making the change comes in, regardless of interest rate.
This article was revised by Keith Gumbinger.
