Prime Rate at 3.25%, CD rate at 5.3%. Is it worth tapping a Prime - 0.5% HELOC and buying CDs?

[SMS]

I have a HELOC that is set to prime - 0.5%, so it's 2.75% as of today. I
can buy a 7 year CD with a yield of 5.3%. So I could make 2.55% on $100K
or so, or $2500 per year. Other than the chance of the prime rate going
up to more than 5.8%, is there any risk in doing this? Of course I have
to pay the HELOC off from other funds since the CD money will be locked
up, but that's not a problem.

[JR Weiss]

"SMS" <scharf...@geemail.com> wrote...

If you have "other funds," invest THEM in the CD, so you make the entire 5.3%!

[Rick]

You may want to look at how the interest rates are calculated. CDs
are paid usually monthly and it is always the same. However, HELOC
are calculated differently where most of the interest is paid up
front. That is to say, if the interest rate changes quickly, you may
be stuck paying the HELOC with much of the principal remaining and the
CD being worthless.

Regards,

Rick

[Shaun Eli]

> You may want to look at how the interest rates are calculated.  CDs
> are paid usually monthly and it is always the same.  However, HELOC
> are calculated differently where most of the interest is paid up
> front.  That is to say, if the interest rate changes quickly, you may
> be stuck paying the HELOC with much of the principal remaining and the
> CD being worthless.
>
> Regards,
>
> Rick

Nope, the only difference is that a home equity loan will compound the
interest and the CD will probably pay simple interest that you can't
reinvest at the same rate as the CD.

There are two major risks:

1. Interest rates rise so your home equity rate goes up but the rate
you receive on the CD is fixed, so you have what's known as negative
carry. In plain English, you lose money.

2. If you want to sell your house you have to pay off the HELOC so if
you don't have the money you'll have to break your CD, possibly at a
great loss if rates have increased.

There's also the possibility that your HELOC isn't Prime minus a half
percent forever, that it's an introductory rate, but you'd have to
check that.

Oh, and I think, but I'm not sure, that interest on a home equity loan
might be deductible only to some extent (like up to the purchase
price, or something like that) whereas the interest on the CD is fully
taxable.

For what it's worth, playing these kind of interest rate games, often
on a more sophisticated basis, is what gets financial institutions in
trouble from time to time. A whole class of them, called Structured
Investment Vehicles, collapsed when their strategy of borrowing short
and lending long didn't work out (for the experts among us, yes, their
liquidity dried up and that's really what killed them, but part of the
reason for the liquidity loss was their stategy).

Shaun Eli
www.BrainChampagne.com
Brain Champagne: Clever Comedy for Smart Minds (sm)