Home Equity Line of Credit

HELOC

A “HELOC“, or “home equity line of credit,” is a type of home loan that allows a borrower to open up a line of credit using their home equity as collateral.

It differs from a conventional home loan for several different reasons. The main difference is that a HELOC is simply a line of credit a homeowner can draw from, up to a pre-determined amount set by the mortgage lender, whereas with a typical mortgage, the amount borrowed is the total amount financed.

In other words, a HELOC is a lot like a credit card because of its revolving balance nature. When you open a credit card, the bank sets a certain credit limit, say $10,000. You don’t need to pay interest on the total amount, or even withdraw or spend any of the $10,000, but it is available if and when you need it.

That’s also how a HELOC works. Your bank or lender will give you a line of credit for a certain amount, say $100,000. And you can draw upon it as much or as little as you’d like, up to that $100,000, if and when you want.

Generally, you will be required to make an initial minimum draw, say $10,000 or $25,000, depending on the total line amount. This ensures the bank actually makes money on the transaction, and doesn’t just give you a line of credit you never touch.

At that point, you can borrow from it, pay it back, and then borrow again. Or never touch it and just set it aside for a rainy day.

Additionally, most HELOCs allow you to make just the interest-only payment, instead of having to pay back the principal. This keeps payments low while also giving homeowners access to much needed cash.

It’s a flexible choice because you get the option to use the line of credit if you need it, without having to pay interest if you don’t.

Most people use the funds to pay for things like college tuition, home improvements, higher-interest rate debt, or to fund another home purchase.

Accessing Your Funds with a HELOC

Once your HELOC is open, you’ll have a variety of options to access the funds.

Most banks will provide you with an access card that works kind of like an ATM debit/credit card. You can make purchases with it and/or withdraw cash at a branch location.

You may also be given the option to transfer funds to a linked bank account, or be given checks that can be written to anyone for any purpose, which are deducted from your credit line.

There may be a bill pay option if you want to use the funds to pay bills, or an option to transfer funds over the phone.

In any case, it should be pretty easy and convenient (and usually free) to access your money.

Interest Rate on a Home Equity Line of Credit

HELOC rate

A HELOC’s interest rate is determined by the prime rate plus the margin designated by the bank or lender.

Many banks will offer borrowers the prime rate with zero margin, or even less than prime. You’ll often see bank ads that say “prime -1%” or something to that effect. Of course, this is usually an introductory rate, and will often go up after the first few months or year.

After that promo period, expect a margin greater than zero plus prime. For example, you might see something like prime + 2%. Prime is currently 4.25%, so the fully-indexed rate would be 6.25%. A well-qualified borrower may get a rate as low as prime + 0.5%.

If your loan scenario is a bit more high-risk, it could carry a margin of 4% or more, which when combined with the prime rate, can be quite hefty. That would make the interest rate 8.25%, which isn’t a very desirable rate.

When shopping for a HELOC, pay close attention to the margin since it’s the one number that you can control. The prime rate is the same for everyone.

Tip: Ask for the margin during the draw period and the repayment period. Sometimes lenders will impose a higher margin during the latter period, which can get expensive!

Downsides of Home Equity Lines of Credit

Many borrowers steer clear of HELOCs for a number of reasons. The main reason being that a HELOC is an adjustable-rate mortgage, tied to prime. Whenever the Fed moves the prime rate, the rate on your HELOC will change.

Usually it’s only .25% at a time, but the Fed raised the prime rate about 20 times in a row since 2004, pushing the rate from 4% to 8.25%, before it began to move the other way. So your interest rate can fluctuate greatly, even if the Fed moves prime in so-called “measured” amounts.

HELOCs generally adjust either monthly or quarterly, depending on the terms specified by the lender. Check your paperwork so you know what to expect after the Fed makes a move.

Also note that HELOCs don’t have periodic interest rate caps like standard adjustable-rate mortgages, just lifetime caps, so the rate can fluctuate as much as the Fed allows it to, up to 18% in California (it varies by state).

Term of a Home Equity Line of Credit

A HELOC normally has a 25-year term, with a draw period and a repayment period. The draw is typically the first 5 to 10 years, followed by the repayment period of 10 to 20 years.

During the draw period, the homeowner can borrow as much as they’d like within the line amount, and can make interest-only payments on the amount drawn upon. There is usually a minimum payment, just like a credit card.

After the draw period, the borrower must pay off the principal of the HELOC, along with the interest. This period is known as the repayment period.

Usually the loan balance is broken down into monthly payments, but there could also be a balloon payment because of the way the loan amortizes. Also note that some HELOCs don’t have a repayment period, so full payment is simply due at the end of the draw period.

Home Equity Lines of Credit Often Serve as Second Mortgages

Most HELOCs are opened behind an existing first mortgage as a source of funds to pay down credit cards or other revolving debt, or for home improvements and other household costs. HELOCs provide flexibility at a relatively low interest-rate compared to a standard credit card.

They can also be used as purchase-money second mortgages to extend financing and allow the homeowner to put less money down on a hom purchase.

In this common scenario, the HELOC utilizes the entire credit line as the down payment, and the borrower must pay interest on the full amount from day one.

For example, if a borrower wanted a zero-down mortgage on a $100,000 property, they could open a $80,000 first mortgage at 80 percent loan-to-value and a 20 percent second mortgage (the HELOC) to cover the remaining $20,000.

Some borrowers may even open a HELOC as a first mortgage, although it is less common and can be fairly risky for a homeowner if the prime rate rises rapidly.

Home Equity Line of Credit vs. Home Equity Loan

With a home equity loan, you receive a lump sum and make monthly mortgage payments on the total amount borrowed, usually at a fixed rate.

A HELOC, on the other hand, not only gives the borrower the freedom to decide when and if to use the money, but also how much they need to pay back and when.

Borrowers generally choose HELOCs as purchase-money second mortgages because the interest rate is lower than closed-end fixed second mortgages.

And HELOCs have an interest-only option which many fixed-end seconds don’t offer. HELOCs also don’t carry prepayment penalties, whereas many fixed-end seconds do.

Once the borrower pays down the HELOC, they also have the option to draw upon it again if they need additional funds, something a home equity loan doesn’t offer.

Common HELOC Fees

Another negative to HELOCs are the associated fees. Some of them require you to order an appraisal, which can amount to several hundred dollars. Others will charge closing costs and an origination fee.

There may also be an annual fee on your HELOC, which could range from $50 to $100 or more per year. Over time that can add up.

HELOCs also tend to come with early closure fees of around $300-$500, although they don’t usually carry an explicit prepayment penalty.

This means if you close your equity line just 1-3 years into the loan, the bank will charge this fee. Again, they want to make money off the deal, so if you close the line too quickly, they’ll probably charge you for it.

Sometimes the fee will be equivalent to what they would have charged for closing costs. For example, they may say you can get a HELOC without closing costs, but charge you those fees later if the line isn’t kept open for a minimum period of time.

HELOC advantages:

– lower rate than a fixed loan
– interest-only option
– no prepay
– ability to choose draw amount you want, when you want
– able to borrow multiple times from same line
– lower closing costs

HELOC disadvantages:

– adjustable rate
– no periodic caps on interest rate
– rate can adjust much higher
– early closure fees
– minimum draw amounts
– annual fees


18 Comments

  1. Elizabeth Steiner Milligan February 21, 2016 at 1:45 pm -

    Thank-you Colin. What you said is what I thought but it made the world of difference to me to have your credibility behind it.

    Sure hope bankers don’t bundle HELOCs and sell them to pension funds and the government.

    I am a spec in the world of finance, but I need to watch out for that spec big time!

  2. Donna February 22, 2016 at 10:45 am -

    Colin,
    Thank you! The information you have provided has been very educational. May I have an opportunity to speak with you privately?

  3. Colin Robertson February 22, 2016 at 6:52 pm -

    Donna,

    I can barely keep up with the comments, but if you have a question go for it. I feel the public ones at least benefit more than just the person who asked.

  4. Colin Robertson February 22, 2016 at 7:20 pm -

    Elizabeth,

    I think the banks keep their HELOCs, which was a major problem for them until property values went back up. But fully-amortizing resets are still a potential problem for them.

  5. Donna February 23, 2016 at 10:19 pm -

    Colin,
    Of course….I understand. Looking for options to restructure an HELOC interest only into a term loan with a lower interest rate. HARP is in place to help consumers refinance Fannie Mae or Freddie Mac mortgages that are 80% loan-to-value and tied to higher interest rates than the current market. In this case, the Lender is not offering a “dig out” plan. Do you know of any recourse that a consumer would have against a situation whereby they have been disadvantaged and held to a high interest rate by the terms of a “variable” HELOC (6.75% floor rate), yet meet and exceed the qualifications outlined for HARP – specifically, never missed or was late on a payment, good credit score rating and 80% LTV? The Lender’s only “negotiation” with the borrower is to take further advantage of the situation and place them in a higher interest ARM plan.

  6. Colin Robertson February 24, 2016 at 7:00 pm -

    Donna,

    I assume most people who couldn’t get a loan mod or some sort of relief on their HELOC either walked away, foreclosed, short sold, or perhaps were able to gain enough equity over the years to consolidate the first and second mortgage into one new loan at a lower rate.

  7. Jane April 9, 2016 at 7:51 am -

    Colin,

    Why do banks almost insist you open a HELOC especially when they are aware you have paid off the mortgage.?

  8. Colin Robertson April 18, 2016 at 10:46 am -

    Jane,

    Probably to make more money like any other company that attempts to cross-sell products with the pitch that you can tap into your equity at any time to pay expenses and unforeseen costs that come up.

  9. Verna July 28, 2016 at 1:26 pm -

    If i already have a reverse mortgage…how can i still get a small loan using my house? would i have to have good credit?

  10. Colin Robertson August 2, 2016 at 8:45 am -

    Verna,

    I suppose it depends on how much money you need, but a HELOC behind a reverse mortgage might be a no go regardless of credit. Not sure any lenders offer that. Other options might include refinancing the reverse mortgage into another reverse mortgage or a standard mortgage (but you may not want a monthly payment).

  11. C Baker November 18, 2016 at 11:55 am -

    My question: in 2006, Bank A originated a first (80% conventional) and 20% HELOC as a 100% purchase as the sale of our first property had not completed. The first was securitized as an 80% LTV, conveniently forgetting the HELOC.
    In 2007 the ownership and servicing rights for the HELOC passed to Bank B.
    The DOT references MERS, and the HELOC agreement was indorsed in blank (does this permit Bank B to alter the terms of the HELOC agrement – unlike the conventional note, there is no language in the HELOC agreement relating to transfer of the contract .
    There seems to be some debate as to whether a HELOC is a negotiable instrument.How can bank B become creditor and servicer of the HELOC when the “note” stipulates it is an agreement with Bank A. I never took out a new HELOC with Bank B to pay off Bank A, so what obliges me to pay Bank B?? As for the note, I have no idea who holds it, although Bank C claims to by virtue of taking over Bank B (although the HELOC may have been securitized by Bank B).
    So, who should I be paying – or who could foreclose if I stop??

  12. Paul April 26, 2017 at 3:56 pm -

    Hi Colin,

    I have applied for ARM 5/5 which has been approved for my house 338K @ 3.75 % with 2% change up or down every 5 yrs. Our Credit union is giving 5% down payment option with no PMI also no Closing Cost. It sounds too good to be true but it is something that suits my current situation Fixed Rate Loans being very close to 4% am I going for the correct option?

  13. williams April 28, 2017 at 9:15 am -

    What happens if a HELOC is a first mortgage and the home owner takes out a second mortgage and the homeowner defaults on the Heloc and the property is foreclosed.

  14. Colin Robertson May 1, 2017 at 11:27 am -

    Paul,

    There are 5/1 ARMs that are in the high-2% range as far as I know, so once you factor in MI being paid by the lender rates could be in the low-mid 3% range. The rate also moves based on how much you’re paying in closing costs. If you can get a 30-yr fixed for say 4% the savings may not justify the risk of the rate increasing on the ARM, but that’s up to you and also dictated on what you plan to do with the mortgage/home over the long-term.

  15. Colin Robertson May 1, 2017 at 11:33 am -

    Williams,

    It depends what action the investor (of the HELOC) wants to take. The HELOC lender will probably still be in the first-lien position in terms of recovering funds.

  16. Jim May 4, 2017 at 9:02 am -

    Hi Colin,
    It appears that you have a lot of knowledge regarding HELOC’s. So, here is one for you if you don’t mind. I am refinancing my home using VA and have had a HELOC currently in a repayment mode. The bank with the HELOC when asked to approve a subordination is saying they won’t approve when total closing costs are greater than 4% of the loan amount. Have you heard of such a thing and how can a bank providing a line of credit dictate this? when it is a small HELOC compared to the “big picture”?

    Thanks so much!

  17. Lyn June 30, 2017 at 3:21 pm -

    I have a rental condo with a Variable rate line of credit for $250,000. The current rate is 5.75% with a current principal balance of $240,453 which paid for the condo. I also have a regular home mortgage on my permanent address. Can you refinance a HELOC? Or do you suggest I look for a better rate HELOC to replace this one??

  18. Colin Robertson July 7, 2017 at 12:08 pm -

    Lyn,

    Yes, it’s possible to refinance a HELOC, aka pay it off with a traditional first mortgage. It’s pretty common to do actually; a borrower will refinance their first and second into one loan once the balances are low enough to allow it. You could look at another HELOC but the Fed has been pretty open about raising rates (which will raise the prime rate tied to the HELOC).

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