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.
For example, using a standard mortgage you might borrow $150,000, which would
be paid out in its entirety at closing. Using a HELOC instead, you receive the
lender’s promise to advance you up to $150,000, in an amount and at a time of
your choosing. You can draw on the line by writing a check, using a special
credit card, or in other ways.
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 is risky, for reasons
discussed in a moment.
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.
For example, 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.
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.
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.
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.
Note: Some HELOCs are convertible into fixed-rate loans at the time of a drawing.
This is a useful option for borrowers who draw a large amount at one time.
HELOC rates are tied to the prime rate, which some argue is more stable than
the indexes used by standard ARMs. In 2003, this certainly seemed to be the
case, since the prime rate changed only once, to 4% on June 27. However, as
recently as 2001, the prime rate changed 11 times and ranged between 4.75% and
9%. 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, which puts them roughly at 8% to 11%. HELOCs have no adjustment caps,
and the maximum rate is 18% except in North Carolina, where it is 16%.
Don’t compare the APR on a HELOC with the APR on a standard loan because they
mean different things. The APR on a HELOC is the interest rate, period. Among
other things, it does not reflect points or other upfront costs, as the APR
on standard loans does. Requiring lenders to show the interest rate on a HELOC
twice is a strange way to protect borrowers, but there it is.
October 20, 2003
