Higher rates make HELOCs less appealing

Q: Dear Dr. Don,
I will pay off my mortgage in February 2010. Should I open a home equity line of credit now, in case I need extra funds for home improvements in the future? I am 39. My home is assessed at $310,000.
Jennifer Juncture

A: Dear Jennifer,
The good part about getting the line approved while your first mortgage is still in place is that you should have lower closing costs on the HELOC than if you wait until after you pay off the first mortgage. That's because with no first mortgage in place, the HELOC is, in effect, a first mortgage and may have higher closing costs because of it.

The bad part is if you're required to take money out at closing, you'll be paying interest on money you don't have any immediate plans on using.

A HELOC can be a sound financial backstop. However, some lenders are now reducing or pulling these lines out from under homeowners whose properties have declined in appraised value. With plenty of equity in your home, you shouldn't have that issue. But of course, you're not looking to use the HELOC for this reason -- instead, you want the line in case you need to make unscheduled future home improvements.

In general, it makes more sense to use a home equity loan instead of a HELOC to fund home improvements, unless you plan on taking out the HELOC in a refinancing after the improvements are completed. Bankrate's "Home equity loan vs. line of credit?" interactive worksheet can help you decide.

Assessed value determines how the home is taxed. This figure may have little to do with the home's appraised value. I'm going to assume the home's appraised value is at least as much as its assessed value. If it's not, you should take that up with your local tax collector.

A HELOC is an adjustable-rate loan with the interest rate generally tied to the prime rate, which is currently at 3.25 percent. As I write this reply, Bankrate's national average for a HELOC is 5.58 percent. That compares to 8.57 percent for a home equity loan, which is a fixed-rate loan.

While a home equity loan often is a great option for funding home improvements, it isn't likely to be right for you because you're uncertain as to when you'll want to spend money on the home improvements.

While 5.58 percent doesn't seem like a bad rate, historically HELOCs have been priced right on top of the prime rate. Paying roughly prime plus 2.25 percent is a horrible deal if interest rates start to go higher. The 2.25 percent is known as the "pricing spread" to the index. When the prime rate changes, the HELOC's rate also changes at the next reset date. The rate changes to the new prime rate, plus the pricing spread.

Use Bankrate's Compare interest rates feature to find rates in your market and look for lenders offering a rate with a narrow pricing spread.

Congratulations for being on track to pay off your mortgage in your late 30s, early 40s. I often suggest that it's a sound financial goal to pay off your mortgage before you retire. You've done well.