Home-equity loans lose their luster

NEW YORK — For Kim and James Merly, the home-equity line of credit came in very handy. It helped pay for their son's college education, a car and renovations of two rental properties.

Recently, the Fairfield, Conn., couple noticed their interest rate had jumped to 6 percent from the 4 percent they paid in January 2004 when they first opened the account. They decided it was time to pay off the credit line.

Homeowners nationwide have seen their home-equity borrowing costs rise since the Federal Reserve began raising interest rates more than a year ago. Many, like the Merlys, now want to pay off the loans, which no longer look as attractive as they did a few years ago.

The rising rates mean consumers may have to rein in their spending; home-equity lines of credit have been a major source of funding for big-ticket expenditures. That could in turn have broader implications for the economy, which has grown in part because of consumer spending amid record-low borrowing costs.

"There has been a false sense of financial security many consumers have been living under" with low interest rates, said Chris Viale, of Cambridge Credit Counseling. Like credit-card rates, home-equity loan rates have risen over the past year, much to the chagrin of consumers whose rate of savings has dropped as borrowing money has become easy and inexpensive.

Mortgage bankers such as James Nutter Jr. of Kansas City have found more people are coming through his door looking for ways to pay off their home-equity credit lines.

"With the rising rate environment, they want to get rid of it," he said.

Viale said many consumers have been surprised by the steady rise in borrowing costs.

When the Fed changes its monetary policy, it typically does so by tweaking the federal-funds rate, the interest banks charge one another on overnight loans.

The series of rate increases by the Fed that began last summer have in turn prompted U.S. banks to increase their prime rates, which serve as a benchmark for a variety of loans including home-equity lines of credit.

In the beginning of 2004, the prime rate was at 4 percent; it now stands at 6.50 percent. The last time the prime rate averaged about 7 percent was June 2001.

Many consumers are refinancing their first-lien mortgages and withdrawing cash, so-called cash-out refinancings, to pay down home-equity lines of credit that can range in size from $25,000 to $40,000.

According to a study by Freddie Mac, cash-out refinancings rose in the second quarter of this year to levels not seen since the fourth quarter of 2000.

The rise in borrowing costs can be particularly hard for many first-time homebuyers who used home-equity lines of credit as part of what are called piggyback loans.

Unable to foot a 10 percent or 20 percent down payment, many bought homes with little or no money down by taking a first-lien mortgage and one or two home-equity lines, according to Mary Boudreau, owner of Penfield Financial, a Fairfield, Conn., mortgage broker.

"Consumers are looking for some certainty in their payments and the rate they are getting," said Doreen Woo Ho, president of Wells Fargo's consumer-credit group.

She estimates that in the first quarter of this year, U.S. consumers held about $940 billion of home-equity debt.