Your House Can Be
A Ready Source of Cash

July 12, 2004 -- Need some extra money? You may not have to look any farther than your front door.

With real-estate values soaring, a growing number of Americans are turning their homes into a source of ready cash. Last year homeowners pulled out $172 billion in cash when they refinanced their mortgages, according to Economy.com, a research firm in West Chester, Pa. They borrowed an additional $327 billion using home-equity loans and home-equity lines of credit, according to SMR Research Corp., a financial-services market-research firm in Hackettstown, N.J. And thousands of older Americans have used reverse mortgages to raise cash that can be used to pay expenses.

It's hard not to see dollar signs in your home when low interest rates have made borrowing against it quite attractive -- particularly compared with other alternatives, such as piling on credit-card debt. As recently as March, rates on 30-year fixed-rate mortgages were averaging just 5.5%. Rates have moved upward since then and now average 6.42%. Home-equity lines of credit have been an even bigger bargain. Some lenders currently offer lines of credit with rates as low as 3.5%.

In addition, rising real-estate prices have boosted the amount of wealth homeowners can tap. Total equity Americans have in their homes climbed to a record $8.4 trillion in 2003, according to the Federal Reserve Board.

But with interest rates having turned up and expected to keep rising over the next year, anyone thinking about turning their home into a piggy bank needs to take a fresh look at the options. Cash-out refinancings, a staple during the refinancing boom, become less attractive as mortgage rates rise. A home-equity line of credit can be a cheaper source of money, at least initially. But because they come with variable interest rates, borrowers will be saddled with higher interest payment costs if the Federal Reserve Board raises short-term interest rates, as it's widely expected to do.

What follows is a look at how you can tap the wealth in your home and how your choices may be affected by rising interest rates.

Cash-Out Refinancings

When mortgage rates were falling, a cash-out refinancing was a no-brainer for many homeowners. By getting a mortgage with a lower interest rate, homeowners like Michael May could pull out extra cash and still wind up with lower monthly mortgage payments.

Mr. May, an engineering manager in Farmington, Conn., shaved more than a full percentage point off his mortgage interest rate when he refinanced last fall. The deal allowed Mr. May to pay off roughly $55,000 in credit-card debt and still cut his mortgage payments by about $75 a month.

"I paid off all the debt I accumulated when I finished off my basement, paved my driveway and installed a new sprinkler system," says Mr. May. Taking out a larger mortgage made sense, he adds, "because my house has almost doubled in value in five years."

But the attractiveness of cash-out loans is fading fast as mortgage rates inch upward and the chances of getting a lower-cost loan declines. "You're no longer going to lock in the lowest possible rate," says Stu Feldstein, president of SMR Research. He expects rising mortgage rates to cut the volume of cash-out refinancings by as much as 50% this year.

Before embarking on a cash-out refinancing, compare the rate on your current mortgage to the rate you can get by refinancing. "If you can shave one-half to three-quarters of a percentage point off your mortgage...a cash-out is a good option," says Greg McBride, a financial analyst with Bankrate.com. "If the spread is less than that, or current rates are higher than what you're paying, it's off the table. Your closing costs are going to be much higher than with a home-equity loan or line of credit."

Even if you can lower your mortgage rate, cash-out refinancings should be used judiciously. Unless you switch from, say, a 30-year mortgage to a 15-year loan, you're extending the amount of time it will take to pay off your mortgage and, in some cases, you'll increase your total interest costs.

Home-Equity Lines of Credit

With the prime lending rate at 45-year lows, home-equity lines of credit have been a great deal for many borrowers. These variable-rate loans are typically tied to the prime, currently 4%. Some lenders offer loans with rates that are one-quarter to one-half a percentage point below prime.

Home-equity lines have other attractions as well. Unlike with credit-card debt, the interest on the first $100,000 borrowed is typically tax-deductible. Borrowers get the right to withdraw up to a certain amount over time and pay interest only on the amount withdrawn. They typically tap the credit line by writing checks or, in some cases, using a debit card.

Because you don't have to take the money all at once, a home-equity line can be a good way to pay for home renovations, college tuition or other bills that don't come due all at once. It can also serve as an insurance policy that can help meet unexpected expenses.

But home-equity lines also can be risky when mortgage rates are rising. If the Federal Reserve raises short-term rates, the rate on your home-equity line could jump by a similar amount as quickly as the next month. "For people who are really stretched to the limit, it will be a squeeze," says Fritz Elmendorf, a spokesman for the Consumer Bankers Association, a trade association in Arlington, Va.

The risk of rising rates has made some borrowers skittish. Matthew Quigley, a stockbroker who lives near Philadelphia, took out a $20,000 home-equity line two years ago to fund home renovations. He paid off the line this spring when he refinanced his mortgage. "My feeling was that interest rates were going to be heading up," Mr. Quigley says.

There is a ceiling on just how high the rate on a home-equity line can climb, but it may not offer much comfort. Some lenders limit the maximum increase to six percentage points above today's prevailing rates, or cap the rate at somewhere between 13% and 18%. In other cases, the maximum rate is governed by state usury ceilings, which can be above 20%.

If you're looking for a home-equity line, be sure to shop around. Rates on these loans can vary by as much as two percentage points depending on the lender.

There can also be significant differences in fees. Lenders sometimes charge a small application fee and an annual fee, typically $50 to $75, to keep the line of credit open. Borrowers who don't tap their lines can also face a "nonusage" fee, typically $50 a year if you haven't borrowed any money or paid less than a preset amount in interest. If you pay off your line in the first three years, you may also face an early-termination fee of $250 to $500.

Home-Equity Loans

A traditional home-equity loan is structured like a first mortgage. The borrower receives a set amount and makes a fixed loan payment each month. The rate is fixed for the life of the loan -- typically five to 20 years -- and is typically one to three percentage points higher than the initial rate on a home-equity line of credit. The rate on a home-equity loan is typically one to two percentage points higher than the rate on a traditional 30-year, fixed-rate mortgage. But with a home-equity loan, you would be paying a higher rate on a smaller loan than you would if you did a cash-out refinancing, which could raise the cost of your home mortgage.

Because they are more costly, home-equity loans have become less popular than lines of credit in recent years. Lenders originated just $77.7 billion in home-equity loans last year, according to SMR Research, just 2% more than in 2002. By contrast, the dollar value of new home-equity lines climbed 36% last year.

With their fixed rates, home-equity loans can make sense if you need a big chunk of cash at once and don't plan to repay the loan for several years. But even with interest rates likely to rise, "a home-equity line is still the way to go if your payback period is less than three years," says Mr. McBride of Bankrate.com.

Some lenders offer home-equity loans with no upfront costs, but borrowers often pay between $200 and $1,000 in upfront fees. Some lenders also charge an early-termination fee if the loan is paid off in the first three years. As with home-equity lines, there can be big differences in rates and terms, so it pays to shop around.

Reverse Mortgages

Unlike conventional mortgages, reverse mortgages allow borrowers age 62 and older to tap the equity in their homes without making payments for as long as they stay in the home. The loan size depends on the homeowner's age, the home's value and the level of interest rates.

Borrowers must first pay off existing home loans or use the reverse mortgage to pay them off. Most homeowners elect to take the money in the form of a line of credit, but borrowers can also opt for a lump sum or monthly payment. Principal and interest on the loan don't come due until the borrower dies, sells the home or permanently moves out.

"If you are someone who is cash-flow poor, but you have a tremendous amount of equity in your home, this may be a way to free up those monies to improve the quality of your life," says Keith Gumbinger, a mortgage analyst with HSH Associates, a financial publisher in Pompton Plains, N.J.

Still, reverse mortgages have been slow to gain a following. The National Reverse Mortgage Lenders Association, an industry group in Washington, estimates that there are currently 65,000 to 70,000 of these loans outstanding. "It requires a sea change in attitude for...a generation that grew up debt-averse," says Peter H. Bell, the group's president.

Another reason reverse mortgages aren't more popular is that they are costly. Most borrowers can expect to pay 5% to 6% of the home's value in upfront fees, says Ken Scholen, director of the AARP Foundation's Reverse Mortgage Education Project. There are other charges, too, including continuing interest charges and a monthly servicing fee that are added to the loan balance and are paid when the loan ends. While all federally insured reverse mortgages carry the same interest rate, other charges can vary among lenders.

Rising interest rates are a mixed bag for homeowners with reverse mortgages. They reduce the amount of money someone taking out a new loan can borrow. The higher the interest rate, the less money to borrow. But if you take out a line of credit when you get your reverse mortgage, the balance that is still available to you grows larger each month. And the size of the untapped line is adjusted based on prevailing interest rates.

If you're considering a reverse mortgage, be sure to take a look at other alternatives. One is selling your house and moving into something smaller. You'll not only boost the size of your nest egg, but chances are you'll pay less in utility bills and property taxes. A reverse mortgage, says Bankrate.com's Mr. McBride, "is more of a last option."

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