Many consumers who have equity in their homes take out a home equity line of credit to have access to cash if they need it. A HELOC can be a good way to borrow money when you need it at an attractive interest rate. However, HELOCs have a drawback that you should know about before you sign on the dotted line: They often have an adjustable — that is, variable — interest rate. Learn why that’s a bad feature, and what you should do when calculating interest on a HELOC.
What Is a HELOC?
A HELOC is a credit line secured by the equity in your home. You can use it to borrow money, pay the money back, and use it again, almost like a credit card. Because it is secured by the equity in your home, interest rates on HELOCs are lower than credit card rates, although higher than first mortgage — traditional home equity loan — rates. For example, as of Oct. 11, 2017, Lending Tree offered a rate as low as 3.25% APR on a $100,000 HELOC. Also, interest on HELOCs is usually tax-deductible.
A HELOC gives you a credit line you can draw on as you need it, and this arrangement is what distinguishes it from a home equity loan. Suppose you are planning a home renovation you anticipate will cost $150,000. You take out a HELOC for that amount. You need to pay the contractor $40,000 to buy materials, so you write a check from your HELOC for that sum. When the bill comes for the monthly payment, you only pay interest on the $40,000 you’ve spent. A month or two later, you need to pay another $30,000 for the work that’s been done and more materials. You write the contractor another check, and your next payment is for the interest on the $70,000 balance. When the job is done, you write a check to the contractor for $50,000. You’ve spent $120,000 of your $150,000 line of credit, and your subsequent statements will reflect the balance of $120,000.
People also use HELOCs for debt consolidation, funding their children‘s education, and many other reasons. If you have equity in your home, you might see a HELOC as easy money, but make sure you know what you‘re getting into, including how adjustable- and fixed-rate HELOCs differ and how you can benefit from this type of credit.
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Adjustable-Rate HELOCs and Fixed-Rate HELOCs
Most HELOCs have variable interest rates. When banks increase the prime rate, they also increase the rate on any kind of adjustable home loan, including adjustable-rate mortgage loans and adjustable-rate HELOCs. So, the credit line you took out at 3.50 percent might have a rate of 4.00 percent or 4.50 percent within a few months or a year.
A variable HELOC might have a fixed period of time during which you can take out money, known as the draw period. During the draw period, your payments might consist of only interest. You might not be paying down principle. After the draw period, during the repayment period, you will pay both interest and principle, amortized over the remaining life of the loan. A common scenario is to have a 30-year HELOC with a 10-year draw period and 20-year repayment period.
A fixed-rate HELOC, on the other hand, has a fixed rate of interest. Your monthly payment consists of interest and principle, so you pay down the amount you’ve borrowed as well as the interest, right from the beginning.
Drawbacks of a Variable-Rate HELOC
A variable interest rate can be a major drawback for a HELOC. Before you commit to this kind of credit arrangement, understand its implications.
Here are the disadvantages to a variable-rate HELOC:
- False sense of security: Mortgage rates today are low, historically speaking. If you take out a variable-rate HELOC right now, you might be seduced into drawing more money than you need because the interest rate is low. When the rate rises a point or two, or even more, you might be faced with a much higher monthly payment than you expected.
- Temptation to postpone the inevitable: You will probably pay only interest for the first ten years, and your payments might spike in year 11. For this reason, some people refinance their variable rate HELOCs, if their bank allows them to refinance. But doing that is really just postponing repayment. Eventually, you will have to pay the principle or sell your house.
- Budgeting challenges: It can be difficult to budget if you don‘t know what your loan payments are going to be. If you have long-term savings goals, like college or retirement, you might find it challenging to plan how to reach those goals when you don‘t know what your monthly HELOC payments will be.
- Higher borrowing cost: Your total borrowing cost might be higher with a variable rate HELOC, especially in times of rising interest rates. As mortgage rates rise, a fixed rate loan will protect you. Of course, the opposite will be true if rates fall.
- Costlier borrowing with a refinance: You might need to refinance your HELOC after the draw period ends, which will increase your total borrowing costs.
Benefits of a Fixed-Rate HELOC
If you take out a HELOC as a debt consolidation loan or just to have easy access to some extra cash, you will probably be better off with a fixed-rate loan. HELOC rates are low, and your rate will stay low if you choose a fixed rate rather than a variable one. As variable mortgage interest rates rise, your rate will stay right where it is.
Variable-rate mortgages have become rare for these reasons, and variable-rate HELOCs should do the same. So you can have more predictable payments and greater peace of mind, consider refinancing to a fixed-rate loan if you have a variable-rate HELOC.
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