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Your New HELOC: Choose it and Use it Wisely

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If you're thinking about taking out a Home Equity Line of Credit, here's a quick rundown of some of the things you'll need to know before you sign up. For a complete course on Home Equity Loans and HELOCS, how to estimate your home equity and how to shop effectively for the best deals, you'll want to check out HSH's comprehensive Guide to Home Equity.

HELOC Basics

A home equity line of credit (HELOCs) is a revolving line of credit secured by the equity in your home. Like a credit card, a HELOC allows you to borrow funds and repay them to replenish the available amount of credit. Typically, the first five or 10 years of a HELOC constitute the "draw" or "advance" period, when you can use and reuse the money as often as you like; frequently during this period, you only need to pay any interest that is due on the funds you used. The last 10 to 20 years are called the "repayment" period, and during this time you can no longer borrow any new funds and must make monthly payments to retire any outstanding balance you owe. Some HELOCs are fully-amortizing, meaning you make payments of principal and interest, while others are non- or partially- amortizing. Some HELOCs can even end in a "balloon" payment, where any remaining principal must be repaid in a lump sum.

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 depending on the lender's policy. By contract, any rate increases must be tied to the index and in accordance with your loan documents -- no arbitrary rate increases can occur -- but changes can nonetheless be significant at times, and your payment of course also fluctuates with the outstanding balance you owe.

Unlike an unsecured credit card, though, a HELOC is a mortgage secured by your home, and if you fail to repay the funds you borrowed, you could potentially lose your home to foreclosure.

One other item to consider regarding HELOCs: If your financial situation or local housing market changes, a lender can reduce or terminate your HELOC borrowing capability. Should it occur, such a "curtailment" may leave you no access to home equity funds you may have been expecting to have available.

Related: Calculate Your Home Equity

HELOC Features and Components

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, although other financial indicators may be used. Here are HELOC features to look for:

  • HELOC Index: This is the financial benchmark that will govern interest rate changes on your HELOC. Most lenders use the prime rate as a HELOC index, but other indicators including Treasury notes or certain cost-of-funds indicators are not uncommon. The prime rate most often changes in conjunction with changes in the federal funds rate.
  • Margin: The mortgage lender adds a markup called a margin to the index (again, often 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 6.25% after the introductory 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 HELOC you consider, and a smaller one is almost always better in the long run.
  • Rate Floor: Just because you got a great margin doesn't mean that your rate will also 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, so the rate on your HELOC will never go below this level.
  • Introductory rate: When they are offered, this is the interest rate you pay for the first few months of the HELOC. 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 use it early and often, the lower rate makes sense. If it's "just-in-case" backup funding, lower fees make sense.
  • Conversion or Fixed-Rate option: This feature allows you 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. Provided the interest rate available to you is competitive, this can be is a valuable feature in inflationary times when your HELOC's index value may be rising. Converting a revolving account (or a portion of it) 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. Most lines express this as a "ceiling" on how high the rate can go, often 18%. Periodic caps, which limit how much your interest rate can change in any single adjustment are virtually 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, but you should be wary of these. As an example, if you have a HELOC with a total 15-year term, you may be able to draw on it for five years and have 10 years to repay it, but the amount of your payment might be based on a term of 30 years. In this case, your monthly payment will be lower, but you'll still owe a balance when the 15 years is up. Any remaining balance, ("balloon amount"), will have to be repaid in full, or possibly refinanced if market conditions allow.
  • Early-Termination Fees: Some lenders will cover any closing costs for your HELOC; however, if you should close out the HELOC within a given time period (two to three years is common) the lender may then charge you all (or a pro-rates amount of) the HELOC's closing costs at that time.

Refinancing Considerations

Many homeowners take advantage of property appreciation to refinance their first and second mortgages into a new first mortgage. Unless the amount you'll need to repay is less than $2,000, this will be considered a cash-out refinance, and will likely have higher loan costs than a standard rate and term refinance. Still, this can make sense when first mortgage interest rates are low and you no longer need the regular borrowing capability of a HELOC.

When you have carefully thought about how you will use your HELOC, shopping for a HELOC becomes easier, and you can select a loan with the features that matter the most to you.

This article was originally written by Gina Pogol, but was revised by Keith Gumbinger.

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