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?