- The Washington Times - Thursday, January 19, 2006

Consider today’s column a math lesson. From the amount of calls I have received from folks asking the same question, it’s pretty clear that the unusual interest rate environment has placed many homeowners in a conundrum. Here’s a common situation:

A fellow named Charlie calls me up to check whether it makes sense to refinance. Back in 2003, Charlie wisely took advantage of the low fixed rates and refinanced his $175,000 mortgage to a 30-year fixed-rate of 5.75 percent. Six months later, after reading all the hype about skyrocketing home values, Charlie and his wife, Lea, decide to take out a home equity line of credit (HELOC) to pay for several home improvements.

They want to upgrade the kitchen, add a designer fence for their back yard, and install a patio and screened porch, among other things.

Their bank offers them a great deal on a HELOC: Prime rate with no prepayment penalty. Since the prime rate was equal to 4 percent at the time, Charlie and Lea were delighted. And since property values have skyrocketed, the bank offers them a credit line of up to $100,000.

To make the deal even sweeter, the bank allows interest-only payments on the HELOC for the first 10 years.

At 4 percent, the monthly payment of the full line is only $333.

Charlie and Lea close on the deal and six months later, all their improvements are complete. Granted, they ran up the HELOC to the maximum $100,000, but the $333 payment is manageable.

Let’s fast forward to the present. The prime rate has jumped from 4 percent to its current rate of 7.25 percent. Likewise, Charlie and Lea’s interest-only payment soared from $333 to $604 per month.

So I get this call from Charlie asking me what to do. He doesn’t want to touch his first mortgage, sitting pretty with a fixed rate of 5.75 percent. How can he get out of the HELOC with the once-attractive prime rate? To add gasoline to the fire, Charlie is worried that the prime rate will keep climbing.

I tell him most second-trust programs that carry low fixed rates require a short-term, usually five or 10 years. A short-term loan requires hefty payments.

Charlie and Lea tell me that the HELOC payment is still manageable, but they don’t want the payment and interest rate to rise higher.

So I suggest that we run the numbers to see if refinancing and combining both loans would make sense. Charlie reiterates that he doesn’t want to touch his first trust. I tell him that we should 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.

Charlie and Lea’s total mortgage debt is made up of two components: a $175,000 first trust and a $100,000 HELOC. To calculate the weighted average of Charlie and Lea’s total mortgage debt, we take the first-trust component and multiply the loan balance by the interest rate: $175,000 X 5.75 percent equals $10,063.

We do the same thing with the 2nd component: $100,000 X 7.25 percent equals $7,250.

Next, we add the two sums together: $10,063 + $7,250 equals $17,313.

To determine the weighted average, we then divide this sum by the total mortgage debt: $17,313 divided by $275,000 equals 6.3 percent.

When I make this calculation, Charlie and Lea are surprised to learn that despite the great interest rate on their first trust, the actual weighted average interest rate that they are paying for their mortgage debt is 6.3 percent.

Since Charlie and Lea are uncomfortable with the idea of having the rate on $100,000 of their mortgage debt go up, 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 6.3 percent to 6 percent.

What about the payment? They were making interest-only payments on the HELOC. Wouldn’t their payment rise significantly since there would be an additional $100,000 amortized? The answer is no. Since the interest rate on the $100,000 drops from 7.25 percent to 6 percent, I see from my calculator that Charlie and Lea’s total payment would only increase by $24 per month, something they can manage.

There are three distinct advantages to this arrangement. First, $100,000 of their mortgage debt is no longer subject to rate increases. Second, the overall “cost-to-borrow” drops from 6.3 to 6 percent. Third, in exchange for a slight increase in payment, Charlie and Lea have the satisfaction of knowing that a much larger chunk of their monthly payment is going toward the curtailment of principal.

It’s an unusual market. 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 might not be a bad idea to check the weighted average of your mortgage debt.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@pmcmortgage.com).

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