Why Fixed Rate Home Equity Loans Aren't Always Best

Most people think that fixed rate home equity loans are superior to adjustable rate loans. While these loans are more predictable over time, predictability does not necessarily make them the better option. For the vast majority of borrowers, fixed rate loans are more affordable and secure. For some borrowers, however, variable rate loans actually make more financial sense.

Recent Graduates and Young Borrowers

The main group that will benefit from a revolving rate loan is young borrowers, or those who have only recently graduated from college. These people will have low incomes at the beginning of their loans. However, it is very likely they will have a highly increased income by the time the loan needs paid off.

In the beginning, a low monthly payment will be the most important item on their agenda. Toward the end of their loan, though, they will be more likely to afford a higher monthly payment. In order to get the high limits they require at a low monthly payment initially, these borrowers can opt for a variable rate loan. The loans are most affordable when the borrowers have the least amount of money to spend on payments each month. This is slightly risky because it assumes an income will grow more than the monthly payments will grow. It is essential for these borrowers to have a large emergency fund set aside just in case these plans do not come to fruition.

Responsible Revolving Credit Borrowers

A number of home equity loans are distributed on a revolving credit basis. Like a credit card, a revolving credit line allows a borrower to decide when to borrow more money and when to pay down balances. Most revolving credit lines are variable rate loans. The lender can adjust the interest rate based on a number of factors, including how much credit the borrower is using.

If a borrower can manage their home equity line as well as they manage other forms of credit, then it will not be that much more expensive than a fixed rate loan. In fact, the loan may even be cheaper if the borrowers pay down the balance regularly each month. This flexibility works well if a borrower can truly manage the debt and not rack up a high balance.

Borrowers in Transition

Some borrowers may be new to an area or likely to move out of a home in the near future. In this case, they may be expecting to take out a loan for 6 or 10 years but only carry the loan for 3 or 4. Then, they will sell the home and use the profits to close out the loan. In this case, they will take advantage of the low interest and low monthly payments before the loan adjusts to the more expensive rate.

This is a risky idea, because no one can truly be certain they will want to or be able to sell a home at a given point in the future. However, the risk may be worth the very low payments for a few years. This option can also work well for investors to intend to sell a property quickly.

blog comments powered by Disqus