Paying off a high-rate mortgage with a low-rate HELOC can save a lot of money but is also very risky.

Take a Flyer With a HELOC?
February 16, 2009, Reviewed July 24, 2009

Among those who have benefited unexpectedly from the financial crisis are those with HELOCs (home equity lines of credit). HELOC rates are based on the prime rate, plus or minus a margin. The prime rate through the first 6 months of 2009 was 3.25%, the lowest it had been since 1955.

A reader with a HELOC who wrote me recently had a margin of minus .75%, which made her rate 2.5%. Her first mortgage had a rate of 6.5%, and her HELOC lender offered to increase her line by enough to pay off the first mortgage. The prospect of converting a 6.5% loan into a 2.5% loan was indeed enticing. 

Nonetheless, I advised against it. The reason is that she did not expect to pay off the loan for 15 years, and over that long a period, the risk from the HELOC is too high.

The prime rate is extremely volatile. In 1980, it jumped from 13.5% to 21.5% in 2 months! This was an unusual episode, to be sure, but unusual episodes are becoming commonplace these days.

Furthermore, HELOCs offer borrowers no protections against rising market rates. On conventional ARMs, the rate does not change until a specified rate adjustment date, and it is subject to a rate adjustment cap and to a maximum increase over the initial rate. On a HELOC, in contrast, the rate changes whenever the prime rate changes, there are no adjustment caps, and the only maximum rates are those set by the states, which are very high.

I did some simulations using one of my calculators (9ai) to see how long it would take a borrower who refinanced from a 6.5 FRM to a 2.5% HELOC to lose all the benefit of the refinance from a rising prime rate. Assuming the prime rate rose by 1% a year starting in 6 months, break-even occurs in about 7.5 years. The borrower who stays longer than that is a loser. If the prime rate rises by 2% a year, which is still quite modest, break-even becomes 3.5 years.

If the spread between the first mortgage rate and the HELOC rate is 4%, and the borrower expects to be out within 5 years, I think a refinance into the HELOC is a good gamble. If the rate spread is only 2%, I would not do it unless I planned to be out within 3 years.

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