Should Holders of HELOCs Consolidate? Calculating Weighted Average Debt

by: Henry Savage: Realty Times
When property values were soaring and the prime rate was at four percent, home equity lines of credit were a great deal. With the prime at 7.25 percent and poised to rise further, folks with HELOCs are in a conundrum.

The scenario is common in most areas across the country: homeowners gloating about their new-found wealth through skyrocketing home values. With double digit real estate appreciation, home equity proved to be abundant.

What better way to take advantage of a smart real estate investment than to borrow against it? These lucky folks could take out a home equity line of credit (HELOC) equal to or near the prime rate.

Seeing as the prime rate was sitting pretty at four percent only a year and a half ago, homeowners were scooping up these loans like it was new found money stashed away in a forgotten hiding place.

But that was 18 months ago.

Consider this real life situation that accurately depicts the conundrum many homeowners are in today, thanks to the unusual interest rate environment.

Last week, I received a phone call from a client who wisely refinanced his 30 year fixed rate mortgage with me back in 2003, when mortgage rates were near 40 year lows. He refinanced his $275,000 balance to a 30 year fixed rate loan at 5.50 percent. His timing was perfect.

Since then, he reads all the news stories about how home values are continuing to rise at an unprecedented pace. At the same time, he is bombarded with media advertisements for HELOCs being offered at great rates.

So my client decides that it might be a good time to make some home improvements. Among other things, he wants to remodel his kitchen, install a brick patio and build a front porch. He goes to his bank and applies for a HELOC, and is delighted to learn that he's been approved for a $120,000 HELOC with an interest rate equal to the prime rate plus one half percent. Since the prime rate at the time was at four percent, the HELOC was carrying an interest rate of only 4.50 percent. To make the deal even sweeter, the bank allows interest only payments on the HELOC for the first 10 years. The monthly payment of the full line is only $450.

So my client closes on the loan, contracts his improvements and realizes he still has over $30,000 left on the line. He uses the balance and buys a new car. After all, $450 is a very affordable payment.

Let's fast forward to the present day. The prime rate has jumped from 4 percent to its current rate of 7.25 percent. Likewise, the rate on my client's HELOC is now at a much-less-desirable 7.75 percent. The payment spiked up to $775.

What's my client supposed to do? He can't stand the notion of the rate on his HELOC rising from four percent to 7.75 percent, and he hates the idea that the rate can continue to rise even more.

I tell him that he can certainly refinance his HELOC to a 2nd trust with a fixed rate, but most 2nd trust programs that carry low fixed rates require a short term, usually 5 or 10 years. A short term loan requires hefty payments. He doesn't want to increase his payment any more than it has already.

So I suggest that we run the numbers to see if refinancing and combining both loans would make sense. My client tells me that he doesn't want to touch his first trust because the rate is so good -- much lower than the fixed rate loans available today. This is true, I tell him, but his 5.50 first trust rate isn't so hot anymore, now that he has an additional $120,000 in mortgage debt that's costing him 7.75 percent.

I suggest that we calculate the weighted average of his mortgage debt.

A weighted average, by definition, is an average that takes into consideration the proportion of each component, rather than treating each component equally.

My client's total mortgage debt is made up of 2 components: a $275,000 1st trust and a $120,000 HELOC. To calculate the weighted average, we take the first trust component and multiply the loan balance by the interest rate. 275,000 X 5.50 percent equals 15,125. We do the same thing with the 2nd component: 120,000 X 7.75 percent equals 9,300.

Next, we add the two sums together: 15,125 + 9,300 equals 24,425.

To determine the weighted average, we then divide this sum by the total mortgage debt: 24,425 divided by 395,000 equals 6.18 percent.

Despite the great interest rate on the first trust, the actual weighted average interest rate that my client is paying for his mortgage debt is 6.18 percent.

I suggest that we refinance the whole ball of wax to one 30 year fixed rate of 6 percent. Such a rate would carry low closing costs and the interest cost of their mortgage debt would drop from 6.18 percent to 6 percent.

What about the payment? He was making interest only payments on the HELOC. Wouldn't his payment rise significantly since there would be an additional $120,000 amortized?

The answer is no. Since the interest rate on the $120,000 drops from 7.75 percent to 6 percent, I see from my calculator that the principal and interest payment on the new loan would only be $32 higher.

There are three distinct advantages to this arrangement. First, $120,000 of their mortgage debt is no longer subject to rate increases. Second, the overall "cost-to-borrow" drops from 6.18 to 6 percent.

Third, in exchange for a slight increase in payment, a much larger chunk of their monthly payment is going towards the curtailment of principal.

It's an unusual market, folks. Not often do you see an interest rate environment where the prime rate is significantly higher than 30 year fixed mortgages. For those who have very large HELOC balances subject to the prime rate, it may not be a bad idea to check the weighted average of your total mortgage debt.