Home Equity Line of Credit as First Mortgage

With the Federal Reserve stating that interest rates are expected to remain low until 2013 and possibly longer, there is an opportunity available to homeowners with a higher rate first mortgage.  A homeowner could consider paying off their first mortgage (amortized loan) with a home equity line of credit (HELOC) or simple interest loan.  Over the life of the HELOC one may save thousands in mortgage interest and pay off the balance of the loan much sooner.

First it is important to understand a HELOC.  The term home equity line of credit is not interchangeable with the term "second mortgage." A "first" or "second" mortgage only refers to the loan's claim position, not its terms. HELOCs are often referred to as "second" mortgages because there is usually another mortgage against the property when they are taken out.  If one were to default, the lender in second position would not see any money until after the lender in first position had been repaid. However, it is possible to have a HELOC in first position if there is no other mortgage on your home when you open a HELOC or you use the HELOC to pay off your first mortgage.

Let's take a look at how a HELOC could work as a first mortgage.  For our example, let's take a $200,000 30-year conventional loan at a fixed interest rate of 5.50%.  For this loan the payment would be approximately $1,130 per month (roughly $900 interest and $230 principal in initial years).  Total interest paid over the 30 year life of the loan would be roughly $208,000; more than the original loan.  As we know, an amortized loan is mostly interest paid in the early years and mostly principal paid in the later years.  

Currently interest rates on HELOCs are 3.00% or less in some cases.  The interest rate of a HELOC is a simple interest calculation and is not amortized over a set period of time.  Therefore, each payment toward principal reduces the next month’s interest expense. The interest rate is variable so if interest rates rise, the interest charged will increase and vice versa.

For example, a $200,000 home equity line of credit at 3.00% would require a minimum interest payment of roughly $500 per month; almost half of the interest paid on the convential 30-year loan.  If one continues to make the same $1,130 payment each month toward a HELOC, which would result in a $630 payment to principal each month.  If we assume the interest rate stays at 3.00%, the loan could be paid off in roughly 19 years and total interest paid would be $65,000; much less than the total interest paid on the same convential loan.

Even if interest rates increased by .25% each year (HELOCs have variable interest rates), the loan could be paid off in approximately 23 years with total interest paid of roughly $143,000; still much less than the original total interest amount on a conventional mortgage.

While converting a first mortgage to a HELOC may not be the best option for everyone because of the variability of interest rates; in an environment of low, steady interest rates a HELOC could be a great opportunity to pay down a mortgage more quickly versus a coventional 30-year mortgage.  A HELOC is most attractive if a homeowner makes extra payments toward principal, which in turn reduces the monthly interest expense.   

Super Committee Update

Below is an LA times article which came out today regarding the latest on the "super committee."

"With time and compromise slipping out of reach, the congressional "super committee" may punt its toughest deficit decisions to next year rather than strike a deal that would enrage both parties' political bases heading into the 2012 election.  The Joint Select Committee on Deficit Reduction has until Nov. 23 to agree to a package that would reduce deficits by $1.5 trillion over the next decade.

Achieving that goal would require painful compromise — both parties would have to give up political weapons they have hoped to wield over the next year. But failure could roil the financial markets as the holiday shopping season begins and further trash the already record-low approval ratings for Congress.

In an effort to avoid stark failure, a fallback plan is emerging that would push tough decisions on taxes to next year, perhaps into a lame-duck session after the election, according to officials familiar with the panel's discussions.

Under this scenario, the two sides would agree now to a level of revenue from new taxes. They would direct the congressional tax-writing committees to revamp the tax code with fixed dates and goals. The object would be to generate new revenue while lowering corporate rates and keeping the top individual bracket no higher than the current 35%.

The move would allow the two sides to reach the outlines of the deal now, while deferring the most difficult issues until both see who wins the 2012 election. Currently, election politics makes an agreement difficult — each side has used the budget stalemate as a rallying cry and each believes it stands a chance of winning next November and thereby being able to strike a better deal.  If voters deliver a clear verdict in November, Congress might be in a better position to come to terms.

"By kicking it into next year you're basically saying you're going to have this litigated in the next election," said R. Bruce Josten, executive vice president for government affairs at the U.S. Chamber of Commerce.

Even a limited deal, however, as it is being envisioned by those close to the secretive panel, would require substantial political give on the tax and spending issues that have come to define the modern political parties.

Democrats would have to allow sizable cuts to Medicare, Medicaid and other cherished domestic programs, and Republicans would need to loosen their signature anti-tax stance. Any discussion of an overall increase in revenues would probably violate the "no new taxes" pledge that most Republican members of Congress have signed, although a deal might be able to fuzz up the line enough that Republicans would not have to acknowledge having done so.

In proposals that have been exchanged so far, Democrats offered a package that would be made up of equal parts spending cuts and new tax revenues — but would push the tax component to next year.

Under that plan, a new set of "triggers" would be put in place that would be designed to automatically force tax-law changes if Congress failed to act.

No changes in Medicare or other entitlement programs would take effect until the tax changes were adopted.

The proposal was rejected by Republicans, who said the Democrats' insistence on $1 trillion in new revenue was a level they could not accept. They also said the proposed triggers would not be strong enough incentive to reach a deal. The GOP's own proposal offered $250 billion in new tax revenues, along with lower rates.

A deal presumably would have to fall between those two amounts.

Just as in the summer, getting to yes will require substantial give — particularly on the ratio of taxes to spending cuts — that could prove out of reach in the current political climate.

A compromise would assuredly result in an uproar on the political left and right, signs of which have already emerged. AARP is running ads warning lawmakers not to dare cut Medicare or Social Security. Top conservatives have made it clear that compromise on new taxes would be politically unforgivable.

Alienating so many important constituencies just as the 2012 campaign season is underway would be a tall order, even if the result could be followed by a grand political bargain.  But with time running short, many in Congress are loath to walk away from the possibility of a history-making achievement. Never before, experts say, has one group of lawmakers been given as much power as the super committee wields. Any proposal the committee members agree to has a guarantee of an up or down vote in both houses of Congress, bypassing the Senate's ability to filibuster."

Risks Remain Elevated

Along with the news of an apparent final and comprehensive European solution last week was the the report that US GDP rose at an annual rate of 2.5% in the third quarter; higher than expected.  Unfortunately,  investors continued to follow the results of coincident and lagging indicators rather than leading indicators, so the positive GDP figure was taken as evidence that an oncoming economic downturn or slowdown was now "off the table."

We will emphasize that leading indicators are in fact leading evidence of the economy.  As we know, past performance is not indicative of future results.  For example, the ECRI Weekly Leading Index, which we discussed a few weeks ago, is continuing to point to a slowdown in growth.  Of course, it's not a perfect indicator by itself, but its leading properties are useful.  If you go back over the past few decades and look at the points where the index growth rate fell below zero, you'll find that weekly unemployment claims (a coincident indicator) were generally below the five-year average at that time and took 3 to 4 months before unemployment claims climbed over the long-term average.

So the tendency for investors to make predictions from data such as this current data can be dangerous.  It allows investors to be sucked in by temporary reprieves in periods where very negative conditions persist.  Despite the variability in short-term outcomes, and the tendency for the market to advance as the economy declines,  the overall implications are usually negative in terms of risk/reward.  

The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest that recession risks still remain, and combinations of such indicators provide a basis for concern.

For example, since the early 1960's, when the ECRI Weekly Leading Index growth rate has been below -5, the economy has already been in recession approximately 80% of the time.  If in addition, the S&P 500 Index was below its level of 6 months earlier, the economy was already in recession 87% of the time.  Interestingly, when the index was below -7, and the S&P 500 was below its level from 6 months earlier, the U.S economy has been in a recession within 6 months, 100% of the time.

Now, we certainly don't base our economic expectations solely on these data points, as a broad array of other economic data points are mixed at the current time; however we want to be very aware of the data and historical statistical evidence.  Therefore, we would view the sheer abandonment of a recession by the media, economists, as well as investors to be a bit misleading.  Wall Street economists will quickly point to the summer of 2010, when the ECRI's Weekly Leading Index dropped below -10 without a subsequent recession, thanks we believe to the brief stimulative effect produced by QE2.  Although the ECRI itself did not officially observe enough deterioration in its indicators to project a recession last summer.  As we know it is currently projecting a U.S. recession in 2012 based on its leading indicators.  To what degree is unknown at this time - it could be mild or more severe depending on outside shocks; or non-existent if the Federal Reserve steps in with another round of quantitative easing.

Given that nothing in economics is entirely certain, it's possible that this time will be different.  We have seen a lot of firsts over the past few years.  But that possibility is not one that has support in the data.  To avoid a recession, we have to hope for an outcome other than the one that has historically occurred 100% of the time; given the current indicators.  While we can't predict the future, it would seem prudent not to ignore this fact.