Should I lock in my Heloc?

I have a home equity line of credit (Heloc), on which I pay Prime – which is at the moment an uncomfortably high 8.25%. (I think that Prime is always Fed funds +300bp.) This is not debt I'm about to repay overnight, so it seems silly to me that I'm borrowing the money right at the top of the yield curve.

One thing I can do is get a mortgage and use that to pay down most of my Heloc: 15-year rates are more like 5.6%. I wouldn't get rid of my Heloc entirely – it would still be there in case of emergencies, and indeed it would still be there if I couldn't afford my mortgage payment for whatever reason. But my interest rate would come down substantially, and so I'd save money. On the other hand, there are fixed up-front costs involved in getting a mortgage, and I might need to pay a premium if I wanted to avoid prepayment penalties and the like.

Another option is that I "lock in" the rate on my Heloc for six years at 7.25% – much higher than the 15-year rate, and equivalent to a Fed funds rate of 4.25%, which is pretty close to neutral. But there's no cost to doing the lock-in, I don't need to borrow any more money or create a new lien on my property, and I reduce my interest rate overnight.

In this scenario, if short-term rates go up, I'm laughing. If they stay where they are, I'm laughing. Even if they go down by a full 100bp I'm still paying no more than if I'd done nothing. And if they start going back down towards 3.5% (which equates to a Prime rate of 6.5%), presumably then I can start thinking about refinancing the whole Heloc.

So the way I see it, my main cost of locking in now is that I lose the ability to lock in at a lower rate in the future. Even if the Fed funds rate stays on hold, the curve could invert further between overnight and six years, and the lock-in rate could go lower than 7.25%. I'm no expert in options pricing, so how should I value the option to lock in – the thing I lose if I actually do lock in?

And are there other considerations I should be bearing in mind here? My bank is offering me the lock-in option, and given that we're in something of a zero-sum game and my interest payments are their profits, should that in itself be an indicator that I might want to think carefully before doing this?

Posted by Felix at 16:09 EST

Comments

Prime is not necessarily Fed Funds +300bp. Prime is known as an "administered" rate, not a market rate. In essence, prime is whatever the lending bank says it is, although banks always do come to a consensus. Prime is also "sticky", in that it doesn't follow changes in market rates instantly. Thus, prime can differ from bank to bank when one changes its prime rate before others do. The laggards don't necessarily synchronize their changes either.

I haven't charted prime vs. short-term market rates lately, but I think you'll still see the lag and a variable spread between prime and Fed Funds.

I'm keeping my prime-based HELOC (my spread is minus 100bps, which is worth hanging on to).

Something else you might consider is the length of time you expect to carry your current balance in the HELOC. As you said, there are fixed up-front costs to getting a new mortgage; you can "amortize" these absolute numbers and treat them as interest if you stipulate a maturity (just as banks do). This way you can compare rate to rate.

Posted by: HVH at 18:43 EST, February 12, 2007

More from HVH:
Felix, the way you've posed the question, I don't see any way to value the lock-in option unless you forecast rates. You could get fancy and forecast a probability distribution, but the expected value would still be the mean.

The alternative is to hedge: If you can allocate an asset (of equal value to your HELOC) to an instrument which tracks the prime rate, you would protect yourself from future increases in prime. Of course, you'd also be denying yourself any gains from future decreases in the prime rate.

In other words, as I learned in banking, if you don't want to make bets on rate movements, you need to match the rate maturities of your assets and liabilities (Matched-Maturity Asset/Liability Management). This works for banks: they can live with small but predictable spreads because they are allowed to use enormous leverage (the inverse of the reserve requirement).

I'm rather conservative where leverage is concerned, but my education and experience give me some confidence in my ability to predict rate trends. Since I'm keeping my prime-based HELOC for now, obviously I'm betting that short rates will decline. But then my HELOC balance is small enough that interest expense in absolute terms is no big deal.

Posted by: HVH at 21:45 EST, February 12, 2007

Speaking of comparing rate to rate, here's a tool for determining your blended interest rate, which is the real first step to deciding if refinancing at a fixed rate is in your best interest.

You might also consider Bill Polley's experience. And if you find a way to refinance your rate one room at a time, be sure to let him know how you did it!

Posted by: Ironman at 22:36 EST, February 12, 2007

HVH -- Since 1991, Prime has basically been FF + 300 bps. Here's the chart.

Felix -- I think the right response to this dilemma is to shop around for a better rate on a HELOC. Prime is absolutely not the rate banks charge their best business customers, as it's traditionally described to be. Serious loans to business are always based on LIBOR. Prime is a scam to ensure that consumers whose loans are priced as "Prime + xx" (even if xx is 0) pay banks a generous rate. A low loan-to-value HELOC on an otherwise unencumbered property is a very safe loan. You should be able to do better than LIBOR + 290 bps.

Posted by: Steve Waldman at 1:18 EST, February 13, 2007

Felix, the way you've posed the question, I don't see any way to value the lock-in option unless you forecast rates. You could get fancy and forecast a probability distribution, but the expected value would still be the mean.

Eh? As per Black-Scholes, he should be able to get a good estimate of the value of the option by estimating the volatility of rates alone, no?

Posted by: Bernard Guerrero at 10:12 EST, February 13, 2007

I came across your question while looking for similar advice after you did. Looking at a 5.25% prime rate today, I hope you held off...

Posted by: PS at 9:43 EST, March 22, 2008