Switching to a Fixed Home Loan

by Gary Foreman

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Our interest rates are rising on our home equity loan. Is there a way to refinance them to lock in the loan? Also, is there a way to figure out what actual percentage we are paying on this loan factoring in tax deduction?

Don asks two common questions. Before we answer, let's first learn a bit about home equity loans. There are two types. Many consumers refer to any borrowing on their home that's not a mortgage as a "home equity loan." Technically, that's not correct.

A home equity loan is like a regular mortgage or an auto loan. You generally get all of your money at once and make regular fixed payments. Usually the interest rate is also fixed at the time that you take the loan.

The other loan type is a home equity line of credit (HELOC). It gives you the ability to borrow up to a set amount. Somewhat like a charge card. You can borrow as often as you like. Up to your credit limit. Your monthly payment will change with the amount that you borrow. And, typically the interest rate is variable.

Like many people, Don has borrowed against the equity of his home. He's got lots of company. We owe more on home equity loans and lines of credit than we owe on our credit cards.

Don needs to recognize that a variable mortgage will usually have a lower rate than a fixed one. That makes his decision more difficult. Shifting to a fixed rate will probably mean a higher monthly payment for now. At least until rates rise (if they do).

So what should Don do? We can't give him the answer, but we can tell him how to figure it out. He'll want to begin by considering how long he'll be in the house. In other words, consider how long will he be paying a mortgage or homeowners loan.

Next, he'll want to find out how variable his loan is. Often a variable rate loan will have a limit as to how much it can be raised at each adjustment and over the life of the loan. Don will need to check his loan for specifics.

Then he'll need to do a little research to find out what mortgage rates are available to him if he sought new financing. That will depend in large part on his credit score. He can get information from a mortgage broker, a banker or from the Internet.

If Don's a pessimist, he can assume that his variable rate loan will increase by the maximum amount every adjustment period. That will tell him the highest his payments could be. He can compare that to the payments from alternative financing.

Don may find that he wants to stay with the existing variable rate. Right now, the average fixed loan has an interest rate about 2% higher than the variable one. So unless Don is planning on being in his house for a long time and he expects rates to rise significantly, he's probably going to find that he's best staying with the loan that he has.

One other option for Don is to pay down the loan. It's easier to pay back borrowed money when interest rates are low. And it gets harder as rates go up. That's true for all variable rate loans.

It's also a good time to consider whether you want to switch from a variable to a fixed rate mortgage. No one can reliably predict future rates. But, it is safe to assume that it is possible for mortgage rates to rise.

We are on the low side of where rates have been in the past 30 years. According to Freddie Mac, a 30-year fixed mortgage would have cost you 16% in 1981-82. A variable mortgage would have cost you over 11% in 1984. Today's rates have plenty of room to increase.

As a general rule, you want a fixed mortgage when rates are low and a variable mortgage when rates are high.

Finally, Don asked about after-tax interest rates. They're not that hard to figure. Just multiply the interest rate you're paying by one minus your marginal tax rate. If you were in the 28% tax bracket and the home loan rate was 7%, you'd be paying 5.04% [7% x (1 - .28)] if it were deductible.

But, there's a catch that Don needs to remember. Home equity interest is deductible only if you itemize. If you don't itemize, the deduction doesn't do you any good. And, the deduction is limited to interest paid on loan amounts of $100,000 or less.

Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

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