Dear Dr. Don,
I owe $141,000 on a home equity line of credit with 13 years remaining. With the prime rate currently at 3.25 percent, I can afford to put $600 a month toward the principal. I am scared that the prime rate will eventually rise. Would I be better off taking out a 15-year fixed-rate loan at 4.875 percent?
-- Thomas Trepidation
You're smart to think about this now when the prime rate is low. As the prime rate increases, you're likely to see rates on fixed-rate loans go up as well, even though the fixed-rate loans don't have to move in lock step with changes in HELOC rates.
First, you need to know how your current loan is priced. If your HELOC is priced at the prime rate plus zero percent, you may be more willing to take the risk of a rising prime rate because of the low pricing spread.
Most HELOCs are adjustable-rate loans that price at a spread to the prime rate. Bankrate's glossary defines the prime rate as follows: "A common benchmark for consumer and business loans set by banks, usually at a level 3 percentage points higher than the federal funds rate. The rate given to consumers on their loans is often determined as the prime rate plus a certain percentage, which represents the lender's assessment of the risk in lending, plus its profit margin."
The targeted federal funds rate is currently zero percent to 0.25 percent, meaning that the federal funds can't get much lower and neither can the prime rate.
As I write this reply, Bankrate's national average for a HELOC is 5.73 percent, and a home equity loan is at 8.49 percent. If the 4.875 percent loan you're considering is a new first mortgage, it's likely to have higher closing costs than a new home equity loan. That doesn't make it the wrong thing to do, but the additional costs are a factor in the decision to refinance.
Second, you need to have an idea of how long you plan to be in the house. If you're a short-timer, then you may be able to accept the risk associated with the prime rate rising during the short time you plan to be in the home.
If you plan on being in the house for a long time, locking in a fixed-rate loan at 4.875 percent is likely to be the best decision for you because interest rates are likely to trend higher over the next three to five years. You'll take the risk of a rising prime rate out of the equation by locking in that low rate today.
The goal should be to minimize your total interest expense. Although you can never be sure, rates are likely to trend higher from here. Locking in a fixed-rate loan at a low rate today may mean more interest expense short-term, but less over the total time you're in the house.
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