HELOC stands for home equity line of credit, or simply “home equity line.” It is a loan set up as a line of credit for some maximum draw, rather than for a fixed dollar amount. Most HELOCs are secured by the primary property that you own.

HELOCs are convenient for funding intermittent needs, such as paying off credit cards, making home improvements, or paying college tuition. You draw and pay interest on only what you need.

Upfront costs are also relatively low. On a $150,000 standard loan, settlement costs may range from $ 2-5,000, unless the borrower pays an interest rate high enough for the lender to pay some or all of it. On a $150,000 HELOC, costs seldom exceed $1,000 and in many cases are paid by the lender without a rate adjustment.

Most HELOCs are second mortgages. An increasing number, however, are first mortgages, as yours would be if you used it to refinance your existing first mortgage. Using a HELOC as a substitute for a first mortgage can save a lot of money in the short-run, but is very risky, that will be detailed.

HELOCs have a draw period, during which the borrower can use the line, and a repayment period during which it must be repaid. Draw periods are usually 5 to 10 years, during which the borrower is only required to pay interest. Repayment periods are usually 10 to 20 years, during which the borrower must make payments to principal equal to the balance at the end of the draw period divided by the number of months in the repayment period. Some HELOCs, however, require that the entire balance be repaid at the end of the draw period, so the borrower must refinance at that point.

Because the balance of a HELOC may change from day to day, depending on draws and repayments, interest on a HELOC is calculated daily rather than monthly. On a 6% HELOC, interest for a day is .06 divided by 365 or .000164, which is multiplied by the average daily balance during the month. If this is $100,000, the daily interest is $16.44, and over a 30-day month interest amounts to $493.15; over a 31 day month, it is $509.59.

In contrast, on a standard 6% mortgage, interest for the month is .06 divided by 12 or .005, multiplied by the loan balance at the end of the preceding month. If the balance is $100,000, the interest payment is $500, regardless of whether there are 30 or 31 days in the month — or 28.

The Risks of a HELOC

The major disadvantage of the HELOC is its exposure to interest rate risk. All HELOCs are adjustable rate mortgages (ARMs), but they are much riskier than standard ARMs. Changes in the market impact a HELOC very quickly. If the prime rate changes on April 30, the HELOC rate will change effective May 1. An exception is HELOCs that have a guaranteed introductory rate, but these hold for only a few months. Standard ARMs, in contrast, are available with initial fixed-rate periods as long as 10 years.

HELOC rates are tied to the prime rate, which some argue is more stable than the indexes used by standard ARMs. This is an illusion, however, arising from the fact that the prime rate doesn’t change from day to day. In 2003, it changed only once, to a low of 4% on June 27. However, in the next three years it changed 17 times, by .25% each time, reaching 8.25% on June 29, 2006. In 1980, it changed 38 times and ranged between 11.25% and 20%.

In addition, most standard ARMs have rate adjustment caps, which limit the size of any rate change. And they have maximum rates 5-6% above the initial rates. HELOCs have no adjustment caps, and the maximum rate is 18% except in North Carolina, where it is 16%.

There’s no way to predict when increases will happen or how much they will be. Your new monthly payment could be unaffordable, and getting behind on your payments can lower your credit score and increase the amount of interest you owe. The fine print of your HELOC should state a maximum possible interest rate, but if your current interest rate is 6% and the maximum is 20%, that information isn’t going to be very comforting.

When interest rates go up, your monthly payment will go up.

What could be the best advice when considering a HELOC for you? Best to consult a mortgage professional that you trust.  This person should have an understanding of why you would/should consider a HELOC, or other available options.

Amy Fontinelle, financial journalist for Investopedia can provide even more detail in her article, click here.

Cliff Daniels
ActProp.com
720 434 1418
cliff@actprop.com
Boulder Colorado