A loan of nonsense
October 2nd, 2005 | by mbhunter |Kiplinger’s Personal Finance, October 2005 issue, page 94, has a one-pager:
“Lock in your loan?”
The main point of the article is that it’s not always a good deal to go from an adjustable-rate home-equity line of credit (HELOC) to a fixed rate one, despite the fact that the prime rate has been steadily going up with the Federal Reserve’s recent policy of money tightening.
Some of the arguments are legitimate, like the prediction that the prime rate (the rate that a lot of HELOCs are based on) won’t skyrocket. This may not turn out to be true, but since my crystal ball is in the shop, let’s give them the benefit of the doubt. (And that’s a huge benefit, because I have big doubts.) Or, if you’re not going to be staying put for a while, it may make sense to keep the adjustable-rate HELOC rather than pay a lot of refinancing costs to get the fixed rate.
The rest of the arguments just serve to scare people into interest-only scenarios. From the article:
“With a fixed-rate loan, you lose the flexibility to pay only the interest; you’ll have to tackle larger payments designed to retire the loan in five to 15 years.”
This is an article from a personal finance magazine. What is personal finance coming to? Paying only the interest on a loan is “flexibility?” (An interest rate that’s variable and can rise with the tides?) Otherwise, in the inflexible scenario I’ll “have to” pay down the loan? Doesn’t this seem backwards from what it should be? It seems like we’re trading financial responsibility for “Aw, Mom, do I have to?”
Bottom line: Fixed-rate HELOCs have higher rates because the lender shoulders the interest rate risk. Adjustable-rate HELOCs have lower rates initially because the borrower shoulders the interest rate risk. I guess that everyone needs to assess their own situation, but I’m gladly trading a little on rate to avoid sticker shock on my loan payments every time the prime rate goes up.
Further, if it’s interest-only, when does it end? When the borrower’s heirs assume the debt?
Doesn’t seem like much of an inheritance. But hey, it sure was “flexible” for the original borrower!
6 Responses to “A loan of nonsense”
By ncnblog on Oct 2, 2005 | Reply
Good post…of course, I think all debt is dumb. But, I ‘m crazy that way. ncnblog.com
btw, I linked to this post as one of my posts of the day..
keep up the great job!
By Sarah on Oct 3, 2005 | Reply
Interest only loans scare the heck out of me. In my view, the only people it will work out for are the people who are too financially savvy to get into them in the first place.
I actually saw a loan promoted recently that was worse; it allows negative-ammortization because you can opt out of payments if you can’t make them. Yiy!
By mbhunter on Oct 3, 2005 | Reply
ncnblog, thanks very much! I shall do my best!
Sarah, I agree. If the only kind of loan that someone can qualify for is interest-only, that’s a red flag. It indicates that they’re borrowing too much for what they can comfortably afford. Or, if they can afford a fixed-rate loan, they’re doing no better than renting by taking an IO loan.
Negative amortizations are dangerous. They are reasonably safe for the lender in a hot real estate market, but not if it’s cooling off. They’re disastrous for the borrowers because they owe more with each payment.
By Planet HELOC on Oct 4, 2005 | Reply
Nothing prevents you from paying an interest-only HELOC according to a fixed rate amortization schedule. There are thousands of internet calculators where you can create a repayment schedule to follow and update as needed.
The flexibility argument made in the Kiplinger article is a sound one IMHO. In the event of job loss or other financial emergency, the ability to fall back to a smaller, interest-only payment can be huge. A similar tactic would be to take a 30-year mortgage, but pay it down according to a 15-year amortization schedule.
Of course if you don’t have financial discipline (and many don’t), fixed-rate, fixed-payment is probably best. Keep in mind that closing costs for a fixed rate home equity will generally be higher than for a HELOC.
Other flexibility features inherent in a HELOC include the ability to easily switch into and, when necessary, out of 0% credit card balance transfers. This type of move takes great care, but it can save a lot of money.
Not suugesting HELOCs (or any variable rate debt) is for everyone, but neither is a fixed rate loan always the best option.
Nice blog BTW.
By mbhunter on Oct 4, 2005 | Reply
Hi Planet HELOC,
Thanks for your comment, and I’m glad that you enjoy the blog!
I’m very cynical about borrowing. I admit that my knee-jerk reaction to many of the loan options available seems to be a jaded one, in that I assume that the lenders are trying to shoe-horn everyone with a pulse into the mold of a good credit risk. A few years ago many people who can qualify for a loan now would have been shown the door.
Unless the Federal Reserve can magically soften the landing from this credit bubble (doubtful), banks are going to get taken to the cleaners when these adjustable rates ratchet up, the marginal borrowers default, and they get left holding the bag. Then, they finally might toughen up their lending standards, and IO loans will be rare again. Which is as it should be — people should be made to pay back what they borrow!
So yes, IO HELOCs can get you out of a bind. But the reality is that the lenders will be more than happy if you have one and just pay the interest. The “flexibility” of these loans is quite profitable for them, and further if the IO HELOC is adjustable rate, they’ll never have to worry about a negative spread. They wouldn’t offer the loans if it weren’t a fantastic deal for them.
I think that there are much sounder ways to protect yourself against hard times. Like saving!
Thanks again for your comment.