A home equity line of credit (HELOC) is a mortgage secured with a property structured as a line of credit in which a borrower can draw funds from up to a stated limit.
As opposed to a term loan for a fixed amount of dollars, a HELOC is desirable for people who have no need for funds immediately but foresee a need for funds in the near future without knowing for sure how much will be needed.
This set up helps the borrower save on interest costs when the facility is not used.
For example, instead of taking on a straight up cash loan of $100,000 via a standard mortgage, a HELOC can grant the borrower a credit line of up to $100,000. So instead of paying interest on a standard mortgage the moment the funds are disbursed, HELOC will not charge an interest as long as funds are not drawn from the account.
However, the borrower might be subjected to upfront settlement costs that includes a facility fee. And there will of course be the despised annual fee to contend with.
While most HELOC users use the facility as a second mortgage to consolidate debts or pay for personal expenses, an increasing number of homeowners are using HELOCs to refinance the first mortgage… effectively bumping up the HELOC to the first in line.
The dynamics of how it works
A home equity line of credit comes with a draw period and a repayment period.
The draw period refers to the time frame in which the credit facility can be drawn upon. And the repayment period refers to the time frame in which the funds must be repaid.
During the draw period, which can stretch from as short as 5 years to as long as 15 years or more, borrowers are only required to pay interest on the amount used.
This also means that borrower should keep in mind any minimum draw or minimum loan balance requirements.
Interest are calculated on a daily basis as the balance can move day-to-day depending on the frequency in which it is used.
For example, a HELOC on a 5% interest would have a daily interest of 0.0137% (5%/365). If the average daily balance is $50,000, then the daily interest works out to $6.85 ($50,000×0.0137%). Over a 30-day month, the total interest for the month would run up to approximately $205.50 ($6.85×30).
For comparison, a typical mortgage at 5% will have a monthly interest of $50,000 x (5%/12) = $210.
During the repayment period which usually run between 10 to 20 years, the borrower will have to the principal according to the repayment terms of the contract.
For example, assuming a repayment period of 10 years, a borrower with a $50,000 balance at the end of the draw period might have to make monthly payments of $416.67 ($50,000/120) for 10 years.
In some cases, a borrower might have to make a full lump sum payment at the end of the draw period to fully settle and close the account.
Again, this depends on the terms of repayment.
Defaulting could result in the property owner facing foreclosure.
Biggest risk of HELOC
A HELOC is basically an adjustable rate mortgage (ARM) in the form of an overdraft account.
This variable rate gives it the fundamental exposure associated with interest rate spikes just like an ARM.
But it is riskier because typical ARMs work within the framework of an adjustment interval where in the event of interest rate changes, whether it’s a hike or fall, the new rate which the loan would run tun at doesn’t kick in until the adjustable interval says so.
In the case of lines of credit, when there are interest rate changes, the new rate which factors in the new rate of an index rate commences on the first day of the following month by default.
This mean that even if the prime rate, which is the most common index for HELOCs, moves up a notch on 30 November, the new interest on a HELOC would be effective 1 December.
In addition to that, regular ARMs as opposed to HELOCs, come with adjustment rate caps that prevent interest rates on the facility from getting out of control.
However, being secured with property as collateral, interest rates are still more attractive that unsecured credit lines.
How to choose a HELOC
Unlike ARMs, and to a certain extent FRMs, HELOCs are pretty identical products from lender to lender.
Their most critical features tend to be standard among lenders.
- Interest rate based on an index rate which is often the prime rate
- Interest rates that refresh on the first day of each month
- No limit on size of rate adjustments
- Maximum rate cap of usually 18%
- Redemption penalties
With such simple and standard structure, HELOC is the only mortgage variety that a borrower can compare between in a few minutes.
By having actual information on the following, a borrower should be able to quickly identify the best package:
- Introductory rate
- Introductory period
- Minimum draw
- Average account balance required
- Closing costs
- Annual fee
- Penalty fees
Sometimes they even come with low introductory rates during promotions that guarantee a low rate that would hold for a period of time. Rendering rate changes redundant during the introductory period.
Putting too much weight on APR can be misleading.
In fact, it’s best not to even look at APR.
What a borrower should be mindful of is the margin that the lender charges.
Because while the prime rate would probably have little variance among lenders, the spread they put on these credit facilities can vary wildly.
For example, one lender might charge a prime rate plus 5% while another at prime rate plus 3%.
Borrowers who are sold on the introductory rates might overlook the actual interest rate of index plus margin.
This would result in a shock in the mailbox one day.
Many homeowners turn to HELOCs because such facilities allow them to technically avoid going into debt as long as they don’t use it.
This is fine if the account only serves as a backup plan that is unlikely to be used at all.
But if the need for funds is essential, a borrower would save a lot more on interest charges should he figure out how much he really needs and go for a home equity loan instead.
Taking a term loan can be scary as it immediately puts the homeowner in more debt. With that comes with pressure on what to do with the extra funds as interest is being charged as soon as the funds are disbursed.
Yet if you need that money, you need it. No point living in denial.
Although both home equity loans and HELOCs are secured loans, the former tend to have much more attractive terms compared to the latter.