Alternative to mortgage: equity loan

Q. I would like to refinance my adjustable-rate mortgage to lock in one of today's low rates. But I don't want to pay a lot of fees for a new mortgage that would actually make my monthly payments bigger over the next year. Refinancing would cost thousands, which seems like an awful lot for a loan of only about $80,000. What should I do?
A. You might consider a home-equity loan instead of an ordinary mortgage. Many home-equity loans are unusually attractive now.
Yours is a dilemma that confronts many homeowners with adjustable mortgages, or ARMs: They may be happy with the low interest rates they're paying today -- in many cases only 4 percent or so -- but they worry their rates will rise in the future.
It would be nice to lock into a low fixed rate, but refinancing fees can total thousands. That's hard to swallow, especially as the refinancing might make monthly payments bigger, at least for now.
How could that happen?
Because ARM payments are recalculated every year, based on the remaining debt and the number of years left on the loan. Typically, the interest rate is set by adding 2.75 percentage points to the current yield of one-year Treasury bills.
That yield is now about 1.3 percent. So ARMs adjusting now will charge just over 4 percent until they are recalculated a year from now.
Four percent is terrific, but suppose the ARM goes to 8 percent or 10 percent sometime in the future, leaving the homeowner with much higher payments?
Switching back
Many ARM holders would prefer to avoid that prospect by refinancing to a fixed-rate mortgage that will carry the same rate permanently. For many, that predictability is valuable even if for the next year, the fixed rate is 5 percent or 6 percent compared to the ARM's 4 percent.
Unfortunately, a traditional refinancing can involve thousands of dollars in fees. There's a title search, application and appraisal fees, and if you're to get the lowest rate possible, upfront interest charges called points. Each point is 1 percent of the loan amount, and these days the average mortgage charges 1.5 points.
This is why a home-equity loan can work well in some cases.
Like a traditional mortgage, a home-equity loan uses the home as collateral. To get one, you must have equity in the home -- that is, the home must be worth more than the remaining debt on it.
Interest rates on home-equity loans are typically a percentage point or two higher than rates on ordinary fixed-term mortgages.
Looking good
But right now there are some unusually good deals. E-Trade, the online bank and brokerage at www.etrade.com, is charging only 6 percent for fixed-rate home-equity loans .
Most important: There are no fees. No title insurance. No appraisal. Nothing other than a $300 charge if you pay off the loan within the first two years. And interest payments on home-equity loans of up to $100,000 are deductible on your federal tax return.
So if you have enough equity in your home, you could take out a 6 percent home-equity loan and use the money to pay off all or part of the old mortgage.
Granted, you could get a lower rate -- about 5 percent -- with a fixed, 15-year mortgage. That could make more sense if you expect to have the loan long enough for the slightly lower payment to offset the refinancing costs.
By the way, you may see home-equity rates in the 4 percent and 5 percent range. These generally are for lines of credit that work like credit cards. You borrow only when you want. The interest rates are adjusted every month and could go much higher in the future.
That's the hazard you're trying to escape by getting rid of your ARM. So be sure to get a home-equity installment loan with a permanent rate.
To shop for loans, try the Web site of Bankrate.com, the lending information company, at www.bankrate.com.
XJeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at jeff.brown@phillynews.com.