Line blurs between home equity loans, lines of credit

The line is blurring between the fixed-rate home equity loan and the variable-rate home equity line of credit.

When you borrow against your home's equity, you generally have to choose either the equity loan, which you pay off with equal monthly payments over a specified period, or the equity line of credit, which has a revolving balance like a credit card and minimum monthly payments that cover only the interest.

The last few years have seen the introduction of hybrids that carry elements of both equity loans and equity lines of credit. One of the more unusual of these is Wells Fargo's SmartFit Home Equity Account.

The loan that morphs
SmartFit starts out as a fixed-rate home equity loan, then morphs into a variable-rate line of credit. The borrower can choose to fix the initial rate for three, five or seven years. During the fixed-rate period, the minimum monthly payments cover only the interest, although the borrower has the option of paying back some of the principal.

At the end of the fixed-rate period, the remaining balance automatically becomes a home equity line of credit, or HELOC, unless the borrower pays it off in full or converts the balance into another fixed-rate loan. The HELOC's rate adjusts whenever the prime rate changes.

If you are familiar with adjustable-rate mortgages, or ARMs, you can see that SmartFit is similar to a hybrid ARM. A hybrid ARM has an initial fixed rate that lasts for a set number of years (usually three, five, seven or 10), then adjusts annually thereafter. A traditional ARM typically has its first rate adjustment after one year.

Pay more, risk less
There's another similarity between hybrid ARMs and SmartFit: the rate structure. The initial interest rate on a hybrid ARM is higher than that for a traditional ARM, but lower than the rate on a 30-year fixed mortgage. Likewise, the initial rate on the SmartFit is higher than that for a typical HELOC, but lower than the rate on a home equity loan.

The initial rate on a SmartFit loan depends on several criteria, including the borrower's credit score, the length of the fixed-rate period, the ratio of all the mortgage debt to the home's value, and whether the monthly bill is paid automatically via electronic transfer. A person with excellent credit who chooses a three-year fixed period could get a rate at 99 basis points over prime, or 6.24 percent.

That same borrower probably could get a HELOC at 5.25 percent or 5.5 percent or a home equity loan at around 6.75 percent to 7 percent. The initial rate on the SmartFit is in between, with a rate that won't rise for three years. Meanwhile, HELOC rates are expected to climb as the Federal Reserve lifts short-term rates.

An equity loan structured like SmartFit should appeal to the same people who take out hybrid ARMs to buy their homes. A prime candidate for a hybrid ARM would be someone who doesn't expect to live in the house for more than a few years before moving on.

SmartFit "is for those customers who really are concerned about rising rates and who want to keep their financing costs reasonable, but don't want to take the risk … to subjecting themselves to a continually escalating prime," says John Barton, executive vice president of Wells Fargo's consumer credit group.

He says the loan program is a good fit for homeowners who are tackling major house renovations or need the money for tuition, medical expenses or "bigger kinds of one-time or larger multiple kind of purchases."

Interest charged on entire loan amount
Compared with a HELOC, SmartFit has one major shortcoming: you pay interest on the entire amount from the get-go. With a HELOC, you pay interest on the loan balance, not on the entire line of available credit. For example, you might have a credit line of $50,000, but if you borrow $10,000 of it, you pay interest on just the $10,000 -- not on the $40,000 of available credit that you haven't used. With SmartFit, you get all the money in a lump sum, whether or not you need all of it at the beginning, and you pay interest on it.

On the other hand, the rate on a SmartFit is lower than on a comparable home equity loan, which is received as a lump sum. The monthly payments on a home equity loan include principal, while the minimum payments on the SmartFit cover only the interest. That makes SmartFit more flexible (because you can choose whether or not to pay toward principal each month), but potentially hazardous for borrowers who lack self-discipline.

Wells Fargo and other lenders, including Washington Mutual, offer another fixed-rate option for HELOC borrowers: They allow you to set aside a portion of a home equity line of credit and pay a fixed rate on it, paying off that slice of the loan over a set period. For example, if you can have a $50,000 line of credit, and you want $20,000 to buy a car, you can borrow that amount out of the HELOC at the prevailing rate for a home equity loan and pay it off over five years.

"The appeal is matching the purpose of the money with the term and the payment schedule," Barton says.

Source: BANK RATE