Home Equity Loan Advice: Why Home Equity Rates Are Higher Than 1st Mortgage Interest Rates
By Katharine Norman
The interest rates for home equity loans are higher than first mortgages because, in most cases the risk factor is greater for the loan in second position. Mortgage lenders have evaluated payment defaults, and year after year and almost always the results come out the same.
Borrowers who take out 2nd mortgages are more likely to default than if they had taken out a first mortgage refinance. The figures are close however, and when you look deeper into the numbers it becomes apparent that Lenders are more likely to have equity to receive their recourse if they have to sell the house in a foreclosure procedure.
Refinancing your first mortgage can be a wise decision if you are planning to finance costly improvements on the house, pay for college tuition, or pay-down higher-interest loans.
As property prices have gone up and up, homeowners often find they have more equity than they ever dreamed of when they first bought. Richard Syron, CEO and Chairman of the Federal Home Loan Mortgage Corporation - or 'Freddie Mac' - says "more than a dozen years of sustained growth in housing prices have turned many middle class homeowners into millionaires; put countless children through college; and made the family home the most valuable egg in the American nest". Maybe we can't all be millionaires but, even so, "for the typical family, home equity accounts for the bulk of their wealth," agrees Frank Nothaft, chief economist at Freddie Mac.
It all looks good, so far. But now that you've started to look for that home equity loan - most likely a fixed-term second mortgage, or a line of credit - maybe you're starting to wonder why home equity rates are generally higher than all those great first mortgage packages? There are quite a few reasons. For a start, you are comparing apples and oranges -they're different breeds of loan, and the interest rates reflect the different features offered by each. But how, exactly, are those interest rates set? Frank Nothaft explains that "home equity loans are typically linked to the prime rate . many home equity loans have rates that are 1 percent or more above the prime rate" and, by comparison, "most 30-year first mortgages are typically below prime". The interest rate for a typical home equity loan needs to take several factors into account: the risks to the lender, the duration of the loan, the flexibility offered to the borrower, and the amount of the loan in relation to the amount of equity available (referred to as the Loan to Value (LTV).
The 1st mortgage, of whatever kind, is just that - it's the first lien on your property, and the first in line if you default on your loans. When you got your first mortgage you put your home up as collateral against the loan. If you can't make the payments, the mortgage company can proceed with a collection action - in a worst-case scenario, you lose the house to pay off the loan. And, because it's the primary loan, your first mortgage has priority in any collection action. Essentially, the mortgage company is confident that they'll get their money back if you default. For a second mortgage, the situation's different: whether it's a conventional repayment mortgage or a line of credit (or any other kind of loan), it's second in line if things go wrong. So that's a bit more of a risk to the mortgage company, particularly if the value of your house depreciates, or you take out yet more loans.
And then there's the time factor. The term, or duration, of a home equity loan is usually far less than that of a first mortgage. Most first mortgages are for a period of maybe 15, 20, or even 30-years. That's because most people want to minimize their mortgage payments as much as possible, especially at the outset, and they're in it for the long-haul. And, just think about it: while you're making the payments, you're paying interest, and you're making the mortgage company money. You are a good bet. That's why, when it comes to first mortgages, companies compete with each other so aggressively to get your custom. And they pass that competition on to you, through lower interest rates.
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