Home equity lines of credit (HELOCs) are revolving lines of credit secured by your home equity. The first five or 10 years of a HELOC's life constitute the draw or advance period, when you can use and reuse the money as much as you like, and must only pay the interest due. The last 10 to 20 years are called the repayment period, and at that point you must stop using the line and make monthly payments to retire the balance. Some HELOCs are fully amortized, while others are not.
HELOCs offer more flexibility than any other mortgage product, and for this reason they are the top financing choice for a variety of needs. However, a HELOC's flexibility comes at a price: variable interest rates and payments that can fluctuate widely. By carefully selecting and strategically using your HELOC, you can maximize the upside and hedge against its downside.
Benefits of a Home Equity Line of Credit
While a home equity loan is appropriate when you need a large sum of money for a major renovation, debt consolidation, or the down payment on investment property, a HELOC is your best bet when you don't need the money all at once. In a turbulent economy, access to emergency funds on a moment's notice is worth the small effort and minimal cost of setting up a HELOC. HELOCs can provide cash flow for a business, pay annual college tuition, fund a series of home improvement projects or simply supply an emergency fund. Best of all, you only pay when you actually tap the line.
Drawbacks of a Home Equity Line of Credit
HELOC interest rates can fluctuate like credit card interest rates; they may adjust quarterly or monthly as the prime rate does. Unlike credit cards, any increases must be tied to the index and in accordance with your loan documents -- no arbitrary rate increases allowed -- but the changes can nonetheless be precipitous, and your payment also fluctuates with the balance. To calculate this, take your balance, divide it by the number of months left on the loan, and add the month's finance charge.
HELOC Features to Look For
HELOCs are not all the same, and there are some features that may be more important to you than others. HELOCs almost always carry variable interest rates, which are generally based on the prime rate. The prime rate as of February 2010 was 3.25%, and can be found on HSH.com's page of the latest ARM indexes. Here are HELOC features to look for:
- Margin: The mortgage lender adds a markup called a margin to the prime rate to get the fully indexed rate, which is the rate you pay. The size of the margin is perhaps the most important feature of your HELOC. Understand that the margin may have nothing to do with the start or introductory rate of your HELOC. Just because the start rate is 4% and the prime rate is 3.25%, doesn't mean that your margin is 0.75%. The margin might be 3%, and your rate could jump from 4% to 6% after the intro period ends. Lenders have no control over the value of the index, but they do control the margin. Because of this, you want to compare the margins of every loan you consider.
- Floors: Just because you got a great margin doesn't mean that your rate will be great. Most lenders have minimum interest rates (floors) which can keep you from enjoying today's rock-bottom rates. Even if your index + margin = 4%, you might have a floor rate of 5%, for example.
- Introductory rate: This is the rate you pay for the first few months. If you're just opening up a HELOC to have an emergency source of cash, the introductory rate doesn't really matter because you're unlikely to tap the line right away.
- Loan costs: HELOCs cost a lot less to set up than other home loans -- often just a few hundred dollars -- and the lender may even waive some or all of the charges. What's better: fewer charges or a lower rate? That depends on how you plan to use the line -- if you're going to hit it early and often, the lower rate makes sense. If it's "just-in-case" backup funding, lower fees make sense.
- Conversion: This feature is the ability to convert some or all of your HELOC from a variable line to a fixed-rate home equity loan at one or more points during its life. This is a valuable feature in inflationary times. If you run up a large balance, converting the revolving account to a fixed-rate home equity loan allows you to take advantage of the HELOC's flexibility when you need it, then stabilize your rate and payment.
- Maintenance and other fees: These can include setup charges, annual or monthly maintenance fees, inactivity charges and check or ATM fees. There may also be a prepayment penalty. Choose a loan with a fee structure that will be least burdensome. For instance, if you don't plan to use the HELOC, you won't care about ATM charges, but you wouldn't want inactivity fees.
- Caps: Caps limit how high your interest rate can go over the life of the loan. Periodic caps, which limit how much your interest rate can change in any single adjustment, have become almost nonexistent, but if you can find one it's a good thing to have.
- Balloon: This feature can be useful in keeping your payment low. For example, if you have a 15-year term, you may be able to draw on it for five years and have 10 years to repay it, but your payment might be amortized over 30 years. In this case, your monthly payment will be lower, but you'll still owe a balance when the 15 years is up. The balance, or the balloon, will have to be refinanced or repaid.
Many homeowners take advantage of property appreciation to refinance their first and second mortgages into a new first mortgage. Keep in mind that if you take more than $2,000 from your HELOC in the 12 months before refinancing, and it's not for home improvement, your lender will classify the refi as a cash-out transaction. As such, it becomes subject to additional restrictions and risk-based surcharges.
When you have carefully thought about how you will use your HELOC, shopping for it becomes easier, and you can select a loan with the features that matter the most to you.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.