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Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

What does prime rate mean?

Dear Dollar Diva,

I'm considering refinancing my mortgage and my mortgage company gave me the option of getting a second mortgage with a "prime rate plus 2 percent." I don't want a loan that has a rate that doesn't stay the same.

We've been in our home for four years, and I also can't seem to get my mortgage company to tell me how much equity I have built up.

I'm just looking for a way to get enough money to build a garage and pay off credit cards.

“Prime rate” is a common benchmark for consumer and business loans set by banks, usually at a level 3 percentage points higher than the Fed funds rate. If the prime rate is 8 percent; prime plus 2 would be an interest rate of 10 percent (8 + 2).

The prime rate fluctuates in lock step with the federal funds rate -- the rate that the Federal Reserve sets. The Fed will increase the fed funds rate to slow down the economy, and lower the fed funds rate when the economy needs a boost. Whenever you see headlines that say "Fed cuts interest rates," the prime rate will follow within a day or two. See this Bankrate.com chart for a look at the historic range of the prime rate and its relation to other interest rates.

The type of loan your banker is offering is a variable-rate home equity line of credit (HELOC). HELOCs are usually tied to the prime rate, so when the prime rate changes, so will your monthly payment.

If variable rates aren't for you, you can also borrow against your home equity either with a fixed-rate home equity loan, or with a fixed-rate refinanced mortgage. Use Bankrate's free, objective research to find mortgage rates and home equity loan rates in your area.

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Your mortgage company

The Diva doesn't know what mortgage company you're using, but wonders why you'd want to do further business with them if they won't talk to you. Reputable lenders give you the information you request; and if they don't have it, they'll help you find it.

To find your equity balance, you need to know two things: the current market value of your home and the amount you owe on your mortgage. You can get a rough idea of the current market value by watching home sales in your neighborhood and talking to real estate professionals; to get a precise value, you'll need to get an appraisal. To get the current amount you still owe on your mortgage, use this calculator. You'll need to remember how much you borrowed and when you took out the loan. Use the amortization table with the calculator to arrive at your current balance, then subtract that number from your current market value, and you've got a rough idea of your equity.

Sucking cash out of your home

Now that I've told you how to do what you want to do, here's why you shouldn't do it at all. The Diva strongly advises you to mend your spending habits before you tap your equity.

Your home is not a money tree. It's a place for you to live now and a place for you to build equity so that 30 years from now you'll have a free place to live. With a home, the ordinary person can retire with some dignity, even if the Social Security system crashes. Your home is your castle; treat it with respect.

You've already OD'd on plastic to pay for things you wanted but couldn't afford in the past. The Diva urges you to not chip away at your future to pay for those past sins. And not to build a garage until you can afford to.

"Payment push" to get rid of credit card debt

What you need to focus on now is getting rid of debt, not piling on more of it. The Diva's "payment push" plan of debt reduction works like this:

  • Cut all nonessential spending to the bone.

  • Bring in whatever extra money you can by moonlighting, working overtime, selling stuff you don't need and collecting money people owe you.

  • Open a savings account and get into the habit of saving something every pay period for emergencies. If you can't save $100, save $10; if you can't save that, save $2.

  • Make minimum payments and you'll be in debt forever. Instead, continue making the same payments on your credit cards each month, even though they're more than the minimum.

  • Use all other extra money from belt-tightening, tax refunds, raises, bonuses, moonlighting and any other source to pay down the credit card with the highest interest rate.

  • Once the credit card with the highest interest rate is paid off, shift the "payment push" to the credit card with the next-highest interest rate. And so on until they all disappear.

Once the debt is gone, you'll have plenty of cash left over to build up savings and position yourself to refinance your mortgage. Only this time it won't be to suck equity out of the house; it will be to get a better interest rate so you can build up your equity faster, and pay your loan off sooner.

-- Posted: Feb. 5, 2001

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