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Taking Advantage of Lower Interest Rates
The recent interest rate cuts have put us in a bit of a strange situation. Back in 2005 we locked in a portion of our Home Equity Line of Credit (HELOC) at a 4.55% interest rate for 5 years. That interest rate looked really good through 2005, 2006 and 2007 but in early 2008 it started to just look good, not really good. Now with prime at 3.5% that interest rate doesn't look so good. We could save almost 25% of our mortgage interest costs by getting that 3.5% interest rate instead of the 4.55% we are paying. But we are locked into our 4.55% mortgage until mid-2010, how can we take advantage of these lower interest rates today?
We can take advantage of these lower interest rates by using the lump sum pre-payment option that is built into our mortgage. Most mortgages have two 'accelerated payment' options built into them (when you are shopping for a mortgage you should make sure the mortgages you are considering have both of these options or some variation of these options built in even if you don't think you will ever use them). The first option is the lump sum pre-payment option. This option generally allows you to pay down some specified percentage of your original mortgage amount on a yearly basis. The typical lump sum pre-payment limits are 10%-20%, so every year you can choose to put up to that amount of your original mortgage amount directly into your mortgage. The other option is the increased payment option. This option generally allows you to increase your monthly payments either by some fixed percentage every year or by a fixed percentage over the whole term of the mortgage. The yearly payment increase limits are typically 10%-20% and the payment increase limit over the term of the mortgage is up to 100%. So if you started with a $1500/month mortgage payment you could increase that by either between $150 and $300 every year or by up to $1500 over the whole term of the mortgage.
Ok, that's great we can put a lump sum into our mortgage or we can increase our payments, how does that help us take advantage of current lower interest rates? It isn't like we have a pile of cash laying around and even if we did that wouldn't let us take advantage of the lower interest rates (we would just be getting out of our higher interest rate, not using the lower interest rate). Well, we can take advantage of the lower interest rates by using the variable portion of our HELOC. Currently the interest rate on the HELOC is at prime which is 3.5%. The way our total HELOC works is we have a fixed portion with a 4.55% interest rate that works like a regular mortgage, we have fixed payments and every month a little less of that payment goes towards interest and a little more goes towards principle. We also have a variable portion of the HELOC that has a floating interest rate which right now is equal to prime (although the bank could change that if they wanted to). Every month we make a payment to our fixed portion of the HELOC the principle that we pay off that becomes available to us on the variable side of the HELOC. So say we had a $150,000 total HELOC and we had the full $150,000 fixed when we started. So our fixed mortgage is for $150,000 and we have $0 available in the variable portion of the HELOC. The first month we make a payment of say $1000 and say $600 of that is interest, $400 is principle (which is about a 15 year amortization, not the typical 25 year amortization). Then at the end of the first month the balance on our fixed portion would be $149,600 and we would have $400 of credit available in the variable portion of the HELOC. We don't pay anything for that $400 of available room in the variable portion of the HELOC, it is there for us to use if we want to (and we would have to pay interest on it if we did use it) but we don't have to do anything with it.
Now the picture might be starting to get a little more clear. We have been paying off the fixed portion of our HELOC for about three and a half years now. We also haven't been using the available room in the variable portion of our HELOC. We also chose a fairly short amortization of around 10 years when we set up the fixed portion of our HELOC so every month more than half of our mortgage payment is going to pay down principle and less than half is going towards interest (in fact I think that around 30% is going towards interest currently). So we are now in the position where we have about 30% of our original mortgage amount available on the variable portion of our HELOC which currently carries an interest rate of 3.5% and at the same time we have a portion of our HELOC fixed at 4.55% that has a lump sum pre-payment option. So what we can do is take a lump sum out of the variable portion of our HELOC and put it into the fixed portion of our HELOC and cut the interest rate on that lump some from 4.55% to 3.5%, a savings in the interest we pay of 23%. The only slight wrinkle is that we can only make lump sum payments of up to 15% of the original mortgage amount per calendar year. Lucky for us we are in the last three weeks of the calendar year so we could make one lump sum payment of 15% this month and another 15% lump sum payment next month.
There are actually two advantages to doing this. The first is that the interest paid on the money transferred from the variable portion of the HELOC has been reduced. The second is that since the payments on the fixed portion of the HELOC are fixed and the balance has been reduced there is less interest interest every month so more of the fixed payment is going towards principle instead of interest. Of course the downside is that the total payments that are made to the overall mortgage are higher because the interest on the variable portion of the HELOC has to be paid every month in addition to the regular payment made to the fixed mortgage. So even though from a net worth point of view making a lump sum payment from the variable portion to the fixed portion of the HELOC looks good, from a cash flow point of view it doesn't look as good. Every month the cash flowing into the total combined mortgage (fixed mortgage and interest payments on the HELOC) will be higher than before doing the lump sum transfer.
However, before we jump right in and do this mortgage pre-payment, we need to ask whether we even want to take advantage of these lower interest rates. There is some risk involved in attempting to do this. The 4.55% interest rate that we have on the fixed portion of our HELOC is fixed until the middle of 2010. So we have a year and a half left of a guaranteed rate of 4.55%. The current prime rate of 3.5% is only guaranteed for today. It could change tomorrow or next week or next month and it could change by a lot. There is no protection on where the prime rate could go or how fast it could move. So we have to ask ourselves, do we think that either the prime rate is going to stay below the 4.55% rate we have on our fixed mortgage between now and mid-2010 or do we think that we could pay off the portion of the HELOC we used to pre-pay the fixed mortgage if interest rates went over 4.55% in the next 18 months or so? It isn't an easy question to answer. The current economic, market, and interest rate environment is very volatile and has already shown us how quickly situations can change. A year ago I thought that the 4.55% interest rate we had on the fixed portion of our mortgage was pretty good because prime was at 5.75%. Where prime will be 12 months from now is anyone's guess. So making a lump sum payment in order to take advantage of a lower prime rate requires some careful consideration.