Rule one: Know what prime is
The “prime” rate sounds cool, especially when offered to you. “You are such a good customer… Your credit is sooo good….” Yadda, yadda.
Until the late 1980s, prime was cool, defined as “the rate offered by banks to their best corporate customers.” The prime rate offered by banks was the result of calculating their cost and availability of funds, and prime rates could vary from bank to bank.
But, by the end of the ’80s, top corporate customers stopped using banks except as conveniences — our evolving financial system gave them direct access to credit markets by selling securities.
By 1990 prime had become a benchmark, and more a marketing term than an accurate description. The best customers borrowed under prime, usually a fixed negative spread.
[graphiq id=”dUOOxu2fP0N” title=”Bank Prime Loan Rate” width=”600″ height=”523″ url=”https://w.graphiq.com/w/dUOOxu2fP0N” link=”http://time-series.findthedata.com/l/57842/Bank-Prime-Loan-Rate” link_text=”Bank Prime Loan Rate | FindTheData”]
Prime also became mechanical. The fundamental cost of money in our system is the “Federal funds” rate, the overnight cost of money set by the Federal Reserve. After 1990, prime became Fed funds plus 3 percent, moving up or down whenever the Fed moved, all banks with the same prime.
Historically, prime can be exciting. A period at 22 percent in the early 1980s is still engraved on my soul.
Recently, prime has been deceptively low and stable. The Fed dropped to its first-ever period of 0 percent Fed funds late in 2008, technically “0 percent-0.25 percent,” which held prime at 3.25 percent until last December. Then the Fed cautiously added .25 percent, raising its band to .25 percent-.50 percent and prime to 3.50 percent.
The Fed itself doesn’t know how much higher it will go or how soon, but it projects fed funds at 3.50 percent in another three years, presuming the economy continues to normalize. That would put prime at 6.50 percent — and that’s just normal, assuming the Fed has no inflation-fighting to do.
Which leads to rule two.
Rule two: Never borrow a lot of money at prime for long
In real estate, only two loan types are tied to prime: construction loans and home equity lines of credit (HELOC, pronounced “HEE-lock”). You don’t need to worry about construction loans because they are short term, seldom longer than one year, and the bank won’t let you have one unless a “permanent” lender has promised a “take-out.”
Not Chinese food, just a long-term permanent mortgage to take out (pay off) the construction loan.
Hazard lies in HELOCs. First, there are no rate caps. These are Buzz Lightyear deals, “To infinity, and beyond!”
[graphiq id=”6LGgQI5w5WR” title=”Average HELOC Bank Rates by State” width=”600″ height=”551″ url=”https://w.graphiq.com/w/6LGgQI5w5WR” link=”http://mortgage-lenders.credio.com” link_text=”Average HELOC Bank Rates by State | Credio”]
You might get a teaser rate for a year or two (we saw fixes out to five years when it was clear the Fed was going to stay at 0 percent for a long time, but not now), but then up-she-goes if the Fed goes. They are tempting — interest-only usually for the first 10 years — but then either balloon or begin to amortize steeply for the remaining 10 or twenty years.
HELOCs are great vehicles for the disciplined, and also for those who have the free cash flow, or bonuses, or career trend, or savings to pay them down or off. For every household, “a lot” and “for long” have different meanings, and the last eight years of low and stable rates have lulled some borrowers to sleep.
Fortunately not many. Last week CoreLogic announced that banks had extended “$156 billion in new HELOCs, the largest amount since 2007.”
CoreLogic is a good firm, but I am exhausted with fairy tales presented as “news” to catch eyeballs and clicks. The Fed’s Z-1 says that HELOC and second mortgage balances of all kinds are still falling about $10 billion every 90 days. As of the end of 2015, the total outstanding is only $635 billion and has been falling steadily since the $1.113 trillion peak in 2007.
More than one thing can be true at the same time and in conflict.
The Fed counts outstanding balances, not the amount for which we are approved. So banks may have had a big year approving new lines, but to our credit, we did not draw much on those available lines.
Lenders also have the unfortunate habit of reporting a new loan when, in fact, they renewed an old one. Put faith in the Fed: we do not have a new HELOC binge underway.
Lou Barnes is a mortgage broker based in Boulder, Colorado. He can be reached at lbarnes@pmglending.com.
