Interest is calculated on a Home Equity Line of Credit (HELOC) by using a major interest rate index, such as the prime rate, plus the lender’s margin.
When you go shopping for a loan or line of credit, using your home as collateral, you might be tempted to get a HELOC, as opposed to a traditional home equity loan. HELOCs are more like credit cards than traditional loans because they can be paid off and then used again over the course of the contract, whereas a traditional loan is paid out in a single initial lump sum. Most HELOCs base their interest rate on the prime rate, which is set by the federal government. Most financial institutions use the prime rate as their fundamental benchmark for determining the interest rates they charge. When it comes to a HELOC, however, it is important to be aware that you may be charged an annual percentage rate based on the prime rate, but HELOC lenders will then add their margin to the prime rate – and they won’t tell you about this margin when you apply for your line of credit. That can really add up, especially since the prime rate can change on a monthly basis. In 1980, for example, the prime rate changed over 30 times. If the prime rate goes up, you’ll see your interest rate go up too.
It’s important to get the advice of a financial advisor on all your important financial decisions, but especially so if you’re thinking about getting a HELOC. They’ve got a well-earned reputation for being tricky, and many people have had unpleasant surprises once the initial introductory period has passed. Sit down with your advisor before signing anything.