Many of those that have an outstanding Home Equity Line of Credit (HELOC) loan are debating whether to withdraw additional funds in order to pay off their primary mortgages.

On one level, this probably seems like a silly question/notion, since it essentially involves substituting one loan for another. However, consider that HELOC loans typically accrue interest at variable rates while most primary mortgages accrue interest at a fixed rate. Those for whom such is the case can thus reap immediate savings on interest by withdrawing additional funds under their HELOC in order to repay their primary mortgage.

Of course, there are a couple problems with this approach. First of all, it ignores the possibility that variable rates may soon rise, to the extent that they exceed fixed rates. Under such a scenario, anyone who exchanged their primary mortgage for a HELOC would end up paying more interest. Second, there is a school of though which holds that a HELOC should be repaid before a primary mortgage, and in fact, this idea was confirmed by a recent study, which demonstrated that those who obtain home equity loans are more likely to default on their primary mortgages.

On the other hand, there is no indication that variable rates will rise anytime soon, let alone to the point where they would exceed fixed rates.The Fed has conveyed that rates will remain low for an extended period of time, and when it finally moves to adjust its benchmark Federal Funds Rate, it will probably move slowly. Thus, anyone who used their HELOC to repay their mortgage would probably save money for at least a couple years. Beyond that, it’s hard to predict where mortgage rates will stand.

Another approach would simply be to refinance one’s primary mortgage. While variable rates are currently near record lows, fixed rates are as well. Why risk a rise in variable rates if you can lock in a fixed-rate that as nearly as low? If, however, your credit is not strong enough to qualify for a refinancing, this is not an option. Instead, you can spend 1-2 years rebuilding your credit, before re-applying. If you are confident that you can stand the risk, you can shift the balance of your loan over to your HELOC, and save money in the interim.

According to research, it was not subprime lending that that fomented the housing bubble and ultimately led to its collapse. Rather, it was home equity lending, especially of the cash-out variety. In short, borrowers took advantage of artificially low interested rates and inflated to extract cash, and in the process, lowered the equity balances in their homes. The Federal Reserve Bank summarized this phenomenon as follows: “The rise in the market value of homes since the early 1990s has led to a substantial increase in the level of housing wealth. However, since the mid-1980s, mortgage debt has grown more rapidly than home values, resulting in a decline in housing wealth as a share of the value of homes.”

In fact, Alan Greenspan, himself, estimated that “ four-fifths of the trifold increase in American households’ mortgage debt between 1990 and 2006 resulted from ‘discretionary extraction of home equity.’ ” In other words, most new mortgage debt was created as a result of refinancing (which increased the appraised value of the properties), rather than debt to fund purchases of new homes. “In 2005 alone, U.S. homeowners extracted a half-trillion-plus dollars from their real estate via home-equity loans and cash-out refinances. Some $263 billion of the proceeds went to consumer spending and to pay off other debts.”

The link between cash-out refinancing and foreclosure is surprisingly cut-and-dried: “For every 1 percentage point increase in its share of subprime mortgages that are cash-out refinances, the likelihood of foreclosure in that state goes up by one-third of a percent.” This connection is not difficult to comprehend since borrowers with less equity will necessarily have a more difficult  time repaying their mortgages, either for lack of wherewithal or lack of motivation (perhaps resulting from being underwater).

There are very clear lessons here. First, borrowers should exercise extreme caution when increasing the balance (via a refinancing) of their primary mortgage. This is true if the funds will be pumped back into the home, and especially true if the borrower intends to withdraw some of the proceeds, since this directly increases the likelihood of default.

From a policy standpoint, it’s clear that cash out refinancing should be heavily regulated, if not banned outright. Some experts have pointed to Texas, where the incidence of both foreclosures and underwater mortgages are well below the national averages. By no coincidence, “There, Cash-outs and home-equity loans can’t total more than 80 percent of a home’s appraised value. There’s a 12-day cooling-off period after an application, during which the borrower can pull out. And when a borrower refinances a mortgage, it’s illegal to get even $1 back.” Texas takes these rules so seriously that they are enshrined in the State Constitution.

It’s unlikely that the imminent federal overhaul, in all its glory and fecklessness, will include a similar provision. That’s unfortunate, since the data clearly shows that if a repeat housing bubble is to be avoided, the most effective measure might just be to ban cash-out refinancing.

Tomorrow, Fannie Mae will release the results from its weekly Primary Mortgage Market Survey (PMMS), which should show that average mortgage rates have risen above 5% for the first time since February. If last week’s spike in Treasury yields was any indication, mortgage rates are nearing a 2010 high.

Analysts (myself included) have been predicting this rise in rates for a while. In fact, it is only because of intervention by the Federal Reserve Bank, which has purchased more than $1.25 Trillion in Mortgage Backed Securities (MBS) over the last year that rates have remained this low for this long. It was always only a matter of time before the Fed would curtail its intervention, and the mortgage market would return to equilibrium. That moment has finally arrived: “We will see more volatility in MBS in [a] post-Fed purchasing world, particularly with the Fed not being a backstop buyer after next week,” summarized one analyst.

As if that were not enough, a fiscal crisis in the EU has caused investors to think twice about the sovereign debt of all countries that are operating in the red, including the US. With its Trillion-Dollar deficits, the US is making its creditors nervous, and the response has been a sell-off in Treasury bonds and rise in yields. Mortgage-backed securities trade at a spread to Treasuries, the long-and-short of which is that US fiscal problems have translated into a rise in mortgage rates.

That’s the story for fixed rates; what about variable rates? It turns out that the Fed plays an important role here as well. The Federal Funds Rate (FFR), which is set by the Fed, is currently at an all-time low of near 0%. That means that variable rate mortgages which are are tied to the FFR (and even some that aren’t) are incredibly cheap. As with the Fed’s asset purchase program, there will be an end to this period of record easy monetary policy. Fortunately for variable-rate mortgage borrowers, it doesn’t look like that end will come anytime soon. Based on interest rate futures, it probably won’t be until December (at the earliest) that the Fed finally hikes short-term rates, and even then, the pace of rate hikes will probably be slow.

Those with variable-rate mortgages will probably be tempted to wait until the Fed hikes rates before financing into a fixed-rate mortgage. And who can blame them! Still, you should bear in mind that when short-term (i.e. variable) rates finally begin to rise, long-term (i.e. fixed) rates will likely already have risen. While you might be able to squeeze out some short-term savings by waiting to refinance, you might ultimately end up paying more over the life of the mortgage, especially if you plan to keep it for the full 15-30 years.

If you currently have a variable-rate mortgage and are planning to move in the next 1-2 years, it probably doesn’t pay to refinance, since any interest rate savings will likely be offset by closing costs associated with the refinancing. For everyone else, you should think about refinancing at some point in the immediate future. It’s hard to time the market, and by the time you will actually close on the refinancing, who knows how high rates will have risen. Then again, maybe they will remain constant. It all depends on what you can afford and how comfortable you are with uncertainty.

Across the blogosphere, pundits and financial advisers are baffled by the failure of borrowers to take advantage of unprecedented low rates and refinance their mortgages: “There are quite a few mortgages that are in the money, meaning they are well within the zone where refinancing makes sense. Given where rates are right now, refinance activity should be quite a bit higher than it is.”  Low rates, goes the logic, won’t last forever, and eligible borrowers would be wise not to delay in refinancing their mortgages.

According to a recent report in the Washington Post, however, the fall-off in refinancing applications has little to do with borrower sloth, and everything to do with lender standards and housing market conditions. It’s not as if borrowers are sitting at home biding their time in the hopes that rates will fall still further. On the contrary, a steady faction has continued to seek out refinancing, but a greater proportion is being rejected. According to one lender, the rejection rate has risen from 5% to 25%. The main reason for this trend: the decline in housing prices.

On the surface, one wouldn’t necessarily expect the housing market to significantly affect mortgage refinancings. After all, the two are hardly related, right? Demand for refinancing is a primarily a function of interest rates, and shouldn’t depend on housing prices. However, the recent downturn in prices was so severe that many borrowers no longer meet the basic 20% minimum home equity threshold stipulated by lenders. Anyone who bought in the last five years with a minimal down-payment is probably nowhere near 20%, and may in fact be below 0%. So-called underwater borrowers have no chance of being approved for a conventional refinancing, even with a perfect credit score.

For such borrowers, the only alternative is to buy private mortgage insurance (PMI), and/or rollover a previous PMI to a new (refinanced) mortgage. Why isn’t everyone rushing out to do this? The answer is that it’s prohibitively expensive, requiring both a hefty upfront premium as well as annual payments. Given the uncertainty over housing prices, PMI premiums are rising, and borrowers are balking at committing to paying a premium indefinitely (since there’s no guarantee that one’s equity will return to 20% – at which point insurance is no longer required). The bottom line is that when PMI is factored in, refinancing no longer makes financial sense for anyone whose current mortgage rate is below 6%.

It’s ironic that now that many borrowers legitimately need a refinancing (as a result of the economic recession), they are unable to get one. The federal Making Home Affordable Refinancing Plan was unveiled to address this issue, but it lacks traction; to date, only 200,000 borrowers have been approved through the program, much less than the 5 million borrowers that were initially projected. The program is slated to expire in June.

Don’t let this pessimistic report discourage you. If your current interest rate exceeds 6%, you should still think about applying. [You can use our Refinancing Calculator to estimate savings]. Just maintain realistic expectations, and keep all of your options open.

It is a common misconception that loan modification was “invented” by the Obama administration to combat the current mortgage crisis. On the contrary, they existed long before the government catapulted them into prominence. Despite the fact that loan modifications require less paperwork and are inexpensive to process, however, they have been rare and characterized by drawn-out processes because it was (and still is) difficult to persuade one’s lender to voluntarily modify his mortgage. It had become the norm, then, for borrowers to instead apply for a refinancing, which is expensive and contingent on one’s credit score, but easy to execute for those who are approved.

In light of the Federal Government’s Home Affordable Modification Plan (HAMP), however, the tables have turned completely. Under the plan, lenders are incentivized (such that the costs to borrowers are theoretically nil) to modify loans for at-risk borrowers. Such modifications typically involve reduced interest rates, although some lenders have been known to cut the principal as well. Of course, it is now common knowledge that by almost every measure, this program has been an abysmal failure. Only 66,000 borrowers (as of Decemeber 31) have been approved for permanent modifications, far less than the 3-4 million that was initially touted.

In response, the government has taken to chastising lenders that aren’t aggressive enough in modifying loans, in the form of frequent “report cards.” Lenders blame borrowers, naturally, for not providing the necessary paperwork, and borrowers recriminate that the documentation demands are too onerous. The government’s latest attempt to remedy this discontent is to streamline the paperwork requirements so that borrowers need only to provide a request form for modification, proof of income, and authorization for the lender to check their tax history via the IRS. Despite these hurdles and the fact that delays of many months before being accepted (or rejected, for that matter) are common, the program still holds great appeal for borrowers. In fact, some borrowers are deliberately not making their mortgage payments, in a subtle attempt to demonstrate their financial plight to their lenders.

As a result of this shift and the simultaneous tightening of lending standards, it has become quite difficult to refinance a mortgage. The government has responded by unveiling a parallel program, this one aimed at refinancing. All loans that are owned by Fannie Mae and Freddie Mac (themselves “owned” by the government) are automatically eligible for refinancing. Even underwater loans – up to 125% Loan-to-Value – can be refinanced. Otherwise, the only option for those rejected for loan modification and desperate to refinance, is an FHA refinancing.

Given that mortgage rates are hovering around record lows, refinancing for many borrowers would achieve comparable cost savings to modification. One has to wonder, then, if after the expiration of HAMP and the return of the mortgage market to normal functioning (admittedly, this is an uncertain prospect) if the pendulum will swing back in favor of refinancing. With that possibility in mind, borrowers should think twice about deliberately skipping mortgage payments to increase their chances of modification, because such will also dent their chances of getting refinanced. At the same time, the fact that mortgage rates are projected by many to begin rising in 2010, the window on viable refinancing could soon close.

In short, it seems that for those of you who are genuinely at-risk of defaulting, keep talking to your lender about a loan modification. For everyone else, refinancing is probably still your best – and most realistic – option.

Most mortgage watchers are keenly aware that 30-year mortgage rates are once again sinking, and are now hovering around around 5%. However, few are aware that 15-year rates have been falling even faster. According to the most recent Freddie Mac Primary Mortgage Market Survey, the average 15-year mortgage rate is only 4.46%, just above the record low 4.33% recorded in early October. Only 6 months ago, the spread between 15-year and 30-year rates was .3%. Now it’s .6%. Over that time period, 30-year rates have risen, while 15-year rates have fallen. Unsurprisingly,demand for 15-year mortgages is now outpacing demand for the 30-year alternative.

While it’s impossible to offer a comprehensive explanation for this divergence, most analysts attribute it to the fact that the different mortgages are being utilized by different types of borrowers. “The main users of 15-year loans…are established homeowners refinancing mortgages — people secure enough that they often take on larger monthly payments in order to pay off their loans before they retire…People who take out 30-year loans, by contrast, are generally less well established, with smaller down payments, and require a bigger slice of their incomes to make their payments.” Given the current economic climate, then, it makes sense that lenders are willing to offer a discount to those with an established credit history (i.e. 15-year borrowers), compared to those entering the market for the first time (i.e. 30-year borrowers).

As for those of you trying to decide which duration is most appropriate for you, well, that’s not an easy question to answer. In a nutshell, a 15-year mortgage will save you a tremendous amount of interest (more than half) over the life of the mortgage, but this is offset by a much higher monthly payment. There is also a psychological benefit of being able to pay off the mortgage sooner and not have to worry about spending the rest of one’s life making payments. Summarizes a Freddie Mac rep: “The thinking is that many baby boom mortgagors are taking advantage of the low rates to refi into a mortgage that will enable them to live a relatively care-free retirement life — i.e. free and clear of mortgage debt.”

But with any dilemma, the reality is much more nuanced. For one thing, the monthly payment associated with a 15-year mortgage is significantly higher. Accordingly, one might opt for a 30-year mortgage and simply repay it in accordance with a 15-year amortization schedule. In this way, one retains the flexibility to make the lower (30-year) payment if financial hardship strikes. This “insurance” is inexpensive relative to the overall mortgage, adding $50 a month for a $200,000 mortgage. Skeptics counter that few borrowers are disciplined enough to make the 15-year payment voluntarily and that for those facing financial hardship, making a 30-year mortgage payment will probably be just as problematic as a 15-year payment.

Other proponents of 30-year mortgages point to the extra interest as an advantage, since it is tax-deductible. One clever analyst thought he had figured out a way to save money overall with a 30-year mortgage by exploiting this loophole, but it turns out that the spread between 15-year and 30-year rates has widened to such an extent that “the math no longer works.” Once again, the skeptics rightfully point out that even if you can deduct 30% (assuming a relatively high tax bracket) of your mortgage interest, that still leaves 70% that you are paying to the lender.

Finally, there is also the possibility that interest rates will skyrocket, creating a possible arbitrage opportunity with a 30-year mortgage that wouldn’t exist with a 15-year mortgage. Basically, if you invest the funds that would otherwise have been paid to the lender in a high-yield savings account, you would end up with more money than you would otherwise have had if you simply opted for the 15-year mortgage. But these opportunities are pretty rare, and anyone who argues to the contrary is probably trying to cover up the risk associated with such a strategy.

In short, it’s reasonable to assume that a 15-year mortgage will save you money, compared to a 30-year mortgage. However, the higher monthly payment is an important consideration, and should not be accepted by those with uncertain financial situations. If, on the other hand, your income stream is relatively stable, and you’re eager to escape from under the burden of debt as quickly as possible, the 15-year mortgage is a reasonable choice.

When filing a mortgage application, you will be required by your lender(s) to submit certain documentation, in order to prove both your income and your assets. While your lender will most likely inform you of specific requirements, you can save yourself precious time by preparing all of the documents in advance.

In terms of proof of assets, you should begin by compiling information on all of your bank accounts, including account numbers, the branch address(es), and copies of recent statements. Remember to include information for both checking and savings accounts. You should also plan on furnishing statements of other liquid assets, such as IRA retirement accounts, CD’s, annuities, and estimated cash value of life insurance policies. It wouldn’t hurt to provide valuations for Illiquid assets (real estate, valuables).

The next step is to document your income. This is best achieved through the provision of pay stubs, W-2 withholding forms, and even recent tax returns. If you are self-employed, you should prepare audited income statements for your business. Generally, lenders won’t require more than two years worth of data, but in some cases, they may request additional information.

Even if your creditworthiness has been established (and especially if it isn’t), it wouldn’t hurt to show timely payment of rent and utilities for the last 1-2 years. Your lender will also need to see and legal documents/filings (related to divorce, etc.) in order to determine if any potential liabilities exist.

Prior to the bursting of the housing bubble, it was possible to obtain a competitively-priced loan without providing any or all of the documentation listed above. Reacting to lending standards that were perhaps overly stringent, lenders gradually loosened their requirements. This led to lender complacency and the consequent proliferation of so-called liar-loans, which describe mortgages that require little or no documentation.

In some cases, it is still possible to obtain such loans. Some lenders will accept stated income and/or assets (as opposed to verified income and assets), but you can expect the spread to full documentation loans to be higher than before. According to a recent report, “Less-documented borrowers who reported high incomes were far likelier to default than those whose high incomes were verified – suggestion that loans were made on misleading information.” The report found that applicants were likely to overstate income by 20% on average when verification wasn’t required.

For some applicants, namely those who are self-employed or in-between jobs, a low-documentation loan might still be the best choice. No-ratio loans, whereby income and assets are verified but not used to calculate typical do-not-exceed ratios, might be necessary for those who want to purchase houses that are technically unaffordable.

Of course, you should speak to a loan officer before deciding whether a low-documentation loan is appropriate for you, but it helps to know your options before going in.

The government’s first attempt at creating a refinancing program carried guidelines that were too strict for most borrowers: “Candidates must live in their homes. They can already be behind in their payments or they must prove that they stand at the threshold of default because of financial hardship. The balance of their first mortgage cannot exceed $729,750, and they must make their new payment for a three-month trial period in order to qualify.” The sticking point, however, was that the mortgage value could not exceed the appraised value of one’s home by more than 5%.

From the government’s standpoint, this stipulation was eminently reasonable, since the more underwater one’s mortgage is, the less he has invested in the home and hence the less likely he is to repay. From the standpoint of borrowers – especially those with every intention to repay their mortgages- this requirement made little sense, as it discriminated against them for something they ultimately had no control over.

The government, however, quickly realized how restrictive this clause was: “With home values continuing to drop and the number of delinquent mortgages and foreclosures continuing to rise, it became clear that the 105 percent loan-to-value refinance ratio wasn’t helping enough homeowners lower their monthly mortgage payments.” In its most recent iteration, therefore, this restriction was “corrected,” such that borrowers can now qualify for the refinancing program with a Loan-to-Value ratio of up to 125%. [This is pretty incredible when you consider that a conforming mortgage cannot exceed 80% LTV].

Still, this won’t qualify everyone, especially those in some of the hardest hit areas. According to one economist, “the refinancing program will help those who bought or refinanced their homes in 2003 and 2004 and some who got mortgages in 2004. But he said it still does no good for many who financed houses in 2006 and 2007, when he said prices had ‘gone through the roof.’ ”

Under the new guidelines, borrowers will also be encouraged to shorten the term of the mortgage: “There will be an incentive of 0.125 percentage points on interest rates for opting for a 25- or 20-year term rather than 30 years.” In this way, borrowers that are currently underwater can hopefully move above water more quickly. This will also compensate potential participants for the recent rise in rates, by enabling them to still save on overall interest paid.

Unfortunately for borrowers, the program remains voluntary for banks. While technically you don’t need to be behind (delinquent) on your mortgage to qualify, it seems unlikely that the bank will voluntarily give you a break. In the end, the bank will still decide on a case-by-case basis whether a refinancing or foreclosure is most profitable (or less costly).

I have already blogged about the most important considerations that must be accounted for when deciding whether to refinance a mortgage. With this post, I would like to focus on a few “red flags:” attributes that should cause you to think twice about a re-fi.

The first red-flag is time. From a mortgage duration standpoint, it probably doesn’t make sense to refinance if you are close to (or already passed the halfway point) of your mortgage. For example, if you are 15 years into a 30 year mortgage and refinance into a new 30 year mortgage, you will incur significant additional interest, by effectively lengthening your amortization period by another 15 years. For a modest $200,000 mortgage, this translates into a whopping $60,000 of additional interest payments.

In this case, a better option would be to refinance into a new 15-year mortgage, the net result of which would be no change in the amortization period. If you’re considering such an option, it makes sense to first speak to your lender, who might be willing to modify your interest rate without compelling you to take out a new (i.e. refinanced) mortgage. If a loan modification isn’t an option, the next consideration is how many years you plan to live in your current house. Most experts use two-years as a benchmark; in other words, if you are planning on moving out within the next two years, it will be difficult for you to recoup the closing costs associated with the refinancing.

Red-flag number 3 is your age. If you are nearing retirement age, it probably doesn’t make sense for you to refinance, because then you ensure that you will be making mortgage payments from your savings/pension well into retirement. Who wants to be saddled with such a burden? The only exception is if you have already refinanced in the past and/or have very little equity in your home.

Instead, you might want to consider a reverse mortgage (see yesterday’s post), which allows you to pay off your current mortgage and essentially freeze the equity in your home at a given level (usually no less than 35% of the value of your home) and cash out the difference. As long as you don’t plan to move out/sell your home in the short-term (in which case you “forfeit” some of the proceeds), a reverse mortgage will allow you to remain in your current home indefinitely without having to worry about making mortgage payments (that you would otherwise still be making after refinancing your mortgage).

The final red flag is that you are refinancing for the purpose of debt consolidation/consumption, rather than to save on your monthly payments as a result of a lower interest rate. In recent years, cash-out refinancings have become very common, but I implore you to resist the urge, unless absolutely necessary. It can certainly be tempting to roll all of your credit card debt, auto loans, etc. into your mortgage, which almost certainly has a lower rate. But think of the implications of this: in doing so, you are essentially amortizing the dress you just bought or your car (both of which have limited time use) over 30 years! Besides, if the value of your home goes down, you are now personally on the hook for the difference.