An issue that very popular in the past years is mortgage refinancing to a prime based adjustable rate – meaning a loan with rate that fluctuates along with the prime market rate. The rate often is Prime minus/plus a certain margin rate, thus a loaner that gets prime minus 0.25% will enjoy a 3.25% loan interest rate as long as the prime rate is 3.5%.

Prime adjustable rates are also called flyers and are very common with HELOCs – Home Equity Lines of Credit.

What is a HELOC?

A home equity line of credit is a credit given to a loaner, whereas his home serves as collateral. This form of loan can be used also for non-mortgage related loans such as paying for kids’ education, home improvements puposes, etc.

In HELOC, it is customary for the loaner to be  approved for a specific amount of credit as a percentage of the home appraisal value. The credit left is obviously this figure minus the balance owed on the existing mortgage.

The problem with prime

The main issue is that the prime rate is very volatile,  thus fluctuate to the extreme. Over the past decades we have seen prime rates at 15% and even 20% and more, thus prime related loans were “extremely damaging” to their loaners owners.

Unlike ARM – Adjustable Rate Mortgages – the HELOCs do not give the loaners any protection or cap against a rise in the loan’s interest rate. Whereas in ARMs, the rate cannot change until the rate adjustment period, plus there is a yearly rate adjustment cap (usually 1%-2% annually), on a HELOC the rate simply changes whenever the prime rate changes.

The Rule-Of-Thumb

So, if HELOCs or Prime rate flyers are not really meant to be used for mortgage refinancing, when is it advisable to use them?
The common rule-of-thumb says that if the spread between our original mortgage and the prime mortgage refinancing rate is 4% and above, refinancing can be worthwhile if we expect to be through paying the refinanced mortgages in about four-five years. With such an equation – even if the prime fluctuate, we are more likely to finish most of the interest rate payments and we might benefit from the refinance, though this is still a guess.

HELOC technicality

when a lender approves our request for a home equity line of credit, he does not care wether we use it for mortgage refinancing or any other use. From this point onwards – the loaner can use the credit for lending money according to the prime rate whenever he wants.This will be done through special checks though usually borrowers can use a credit card or other means to draw on the line. Read more on the FED’s page about “What is a home equity line of credit?”