Is the interest rate risk worth it?

Question: We have 7 years left to go to finish paying off our mortgage and we have a manageable amount of home equity borrowing. How wise or risky would it be to consolidate that, borrowing at a lower rate, if the new loan would be a home-equity loan? That's the advice we're hearing from our bank and the stated rate should be lower than the rates we have on our existing mortgage and home-equity borrowing. Is there a reason to think twice about this? Thanks! John, St. Paul, MN

Answer: I would definitely think twice -- three times -- about the making the deal, assuming your current mortgage is a fixed-rate one. My concern is that the price of saving some money on the interest rate upfront is to increase your overall financial risk to rising interest rates later on. 

Here's why: A fixed-rate mortgage locks in your monthly costs. Interest rates can go well above your current rate and it doesn't matter. You'll pay the same rate month after month. (I'm focusing just on a rising interest rates environment.) 

A home-equity loan is a floating-rate mortgage. You'll save some money upfront. You'll also come out ahead if interest rates stay low. But if rates do climb, your monthly tab will go up, too. It's why I'm not enamored with the trade-off.  

Now, I have been wrong about interest rates for at least a year. I expected rates to perk up somewhat last year. They didn't. Still, the economy is once again showing renewed signs of vigor. If the economy continues to recover, I would anticipate that we'll move into a higher interest rate environment. The Federal Reserve will shift gears and tighten monetary policy. The demand for credit will grow. Inflation fears will stir. Taken altogether, rates should go higher eventually. 

Even in a rising rate environment, you could come out ahead if the upfront cost savings are enough and you eliminate the debt within a reasonable time frame. But the downside risk is inherent in the deal.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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