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?
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.
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.
Speaking of comparing rate to rate, here’s a tool for determining , which is the real first step to deciding if refinancing at a fixed rate is in your best interest.
You might also consider , be sure to let him know how you did it!
HVH — Since 1991, Prime has basically been FF + 300 bps.
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.
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?
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…