mortgage and heloc arbitrage

Mortgage and HELOC Arbitrage? Can I Get Some Free Money?

Erik Debt Reduction, Financial Education, Thoughts of a Mastermind 10 Comments

There’s no such thing as a free lunch, but I think I’ve found a potential way to earn some risk free money. I’m always looking for a great deal and I think I’ve found one. By borrowing money at a lower rate than the rate of return on my debt payoff, I can perform mortgage and HELOC arbitrage. I’m a little bit wary of doing this, but I think my math ties out. In this post, I want to share with you my thoughts about potentially using a HELOC to pay off my PMI and perform mortgage and HELOC arbitrage.

mortgage and heloc arbitrageWhat is Arbitrage?

First, what is arbitrage? As defined by Investopedia,

Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price.

Arbitrage is performed when you can exact risk free profit from a difference in pricing on your investments. One common example would be borrowing money at 3% and then investing the money at 4%: you are banking 1% for free.

What is a HELOC?

HELOC stands for Home Equity Line of Credit. A HELOC is a home equity line of credit. It is a loan, using your home as collateral, that lets you borrow up to a certain amount, rather than a set dollar amount. A HELOC (pronounced HE-lock) acts like a credit card: It has a credit limit, and you can borrow against it, pay all or part of the balance, and borrow again up to the credit limit. The interest rate varies with the prime rate.

How does a HELOC work?

The first 5 or 10 years of a HELOC (the period varies by lender) are known as the draw period. During the draw period, you may borrow from the HELOC and the minimum monthly payments are interest only.

After the draw period expires, the repayment period begins. Usually the repayment period last 20 years. During the repayment period, you have to pay principal and interest, so that the entire loan is repaid by the end of the period.

Why am I interested in a HELOC?

I’m interested in a HELOC because I want to set up possibilities where I can access cash quickly in a pinch. Some people will use HELOC funds for home improvements, some for expenses (not the recommended way), and some for investing. I fall into the last bucket: if I find a rental property, a profitable investment opportunity, or another opportunity where I need a substantial amount of cash, then borrowing against my house seems to be a decent idea given my income and home value outlook. (Plus, I work at a bank, and I am able to get an employee discount and a $0 origination fee.) As a result, I applied for a HELOC.

My HELOC Offer

After applying for a HELOC, I received an offer: a credit line of $21,000. This credit line would have a 7.6% variable interest rate with a 10 year draw period, followed by a 20 year amortization period. When I saw this, I was pretty pleased – obviously, I’d love to have a lower rate, but at 7.6%, I saw opportunity.

First, HELOC interest is tax deductible. Therefore, my tax adjusted interest rate is closer to 5.5% (roughly 25% of 7.6%). At 5.5%, I could do a lot of things… fund my IRA, fund a taxable account, or pay down my mortgage to get rid of PMI.

Paying off my PMI with HELOC Funds?

When I saw the 7.6% interest rate, I thought back to my post in February: Pay Down Debt and Invest? In this post, I calculated the rate of return if I paid off my PMI by October:

debt paydown and pmi payoff

Here, I calculated my return at 8.43%. This is a guaranteed 8.43% on my cash over 3.75 years since the debt will be paid off. But, I thought to myself, what if I could arbitrage this return by using debt at 7.6% and keep my cash? Would this be worth it?

Examining My Potential Mortgage and HELOC Arbitrage Opportunity

To get rid of PMI, I’m about $15,000 of principal away. I’ve neglected to pay down extra on my mortgage the past two months and have saved the cash instead.  If I used $15,000 of the $21,000 credit line to pay off my PMI, I would free up $144 of cash flow a month, and accelerate my mortgage amortization. I would have interest only payments on the HELOC of 7.6% on $15,000 for $95.

Looking at this, I’d be saving $49 a month without doing anything, and I’d speed up my mortgage amortization. If I kept paying the minimum on my mortgage (2.625%), it would take 27 more months to get rid of PMI. Therefore, I calculated the rate of return at the 27 month mark to find the profit potential:

mortgage and heloc arbitrage

In 27 months, I’d make $2,235 on my $15,000. This equates to an annualized return of 6.37% that I created out of this potential arbitrage opportunity. This seems to be a pretty good deal, but I’m a little skeptical. One thing to note, the HELOC interest rate is variable with respect to Prime, and as a result could increase. Even if my interest rate doubles (which if this happens, something drastic must have happened in the world), I calculated that I will be profitable. Therefore, this strategy seems to be viable.

Other Options for the HELOC Funds

Other options for the HELOC funds include funding my Roth IRA or just sitting on the credit line if a major emergency comes up.

I really like the prospect of contributing to my Roth IRA with some of these funds because the stock market typically returns 7-8% a year and at a tax adjusted rate of 5.5%, my borrowing costs will be less than the return on my investments. If I’m looking at my finances like they are a business, I should look to leverage these opportunities as much as possible (pun intended).

I’m not sure what to do. Part of my thoughts to get a HELOC are for experimentation and exploration into the world of personal finance products and debt instruments. While I think it’s fantastic to have no debt, I also see the value in using debt to finance profitable ventures. I love personal finance for this reason: there are so many options and each one has it’s pros and cons.

Concluding Thoughts

It seems I’m just moving debt around and this isn’t really solving the PMI issue. Am I missing something? Is my plan worth it if I’m only going to make an extra $2,000 over 2 years? What do you think readers? What would you do with the HELOC funds?

Erik

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Comments 10

  1. If the math works out, then I say go for it. You’re essentially just manipulating your funds to benefit you in the long-run. The only think I’d look into is the HELOC interest rate. 7.6% is really high in my opinion. When I looked into a HELOC recently the rate was closer to 3%. Generally the HELOC interest rate is the prime rate less a certain % depending on the bank (generally 1-1.5%). The Fed Prime Rate today is 4.25% so, I’d think you could get closer to 3-3.5%. In that case, the math would definitely work out in your favor.

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      Author

      Hm, it seems for most borrowers, it’s prime + a certain margin, not the other way around. I’m guessing it also has to do with my credit score, as I’m not quite a prime borrower 🙂

  2. Have you had an appraisal on your home recently? If I remember correctly, you need an appraisal to refinance and ultimately eliminate your PMI – but maybe I’m wrong? It would suck if your appraisal came back just short of what is needed to get rid of PMI. Then, you may have to burn some cash to reduce the principal enough to hit the thresholds to knock off the PMI payment.

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      Author

      I refinanced last year. If you get to 78%, the PMI must be taken off as per the contract. If I get to 80%, I can ask in writing, but there may have to be an appraisal.

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      Author

      Hm. Well, another factor is I don’t have 20% equity in my house, so that makes me a riskier borrower -> hence the increased I.R.

      Thanks for stopping by Gary

  3. I am actually using a HELOC to invest in the stock market. However, I am paying very close attention to the marginal return when I borrow to invest. I want to give myself more room to wiggle as there are risks involved when you invest in the stock market.

    I was fortunate enough to take out a loan that costed me about 2.59% annually and I invest in dividend paying stocks with a portfolio yield of about 3.75%. After factoring in income taxes and interest deductions, this investment is cash flow neutral now. As a result, I get some free money when my stocks increase their dividend payments and I get a free shot at long term capital appreciation.

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      Author
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      Author

      You have to pay it back, it’s a loan.

      There is also an early closing fee – I’m not sure what it is, but if I sell the house in the next 3 years or so, I’d have to pay something.

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