Homeowners across America continue to turn to the home equity line of credit to meet their borrowing needs. In 2015, homeowners borrowed more than $156 billion in HELOCs, according to figures from mortgage-data firm CoreLogic.
Like a credit card, a HELOC is a revolving line of credit — you have a set credit limit against which you can borrow. However, unlike credit cards, with a HELOC, lines of credit are secured against your home. That makes a HELOC more like a mortgage; in fact, a HELOC is often is referred to as a “second mortgage.” Your home equity — the value of your home less any other debt registered against the home — serves as collateral for the credit line.
HELOCs typically include a draw period, which is a fixed time period during which you may borrow money. At the end of the draw period, you might have to do one of the following:
- Renew your credit line.
- Pay off the principal balance and outstanding interest immediately.
- Start the repayment period and make payments toward the principal and the interest over a set term.
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How to Calculate Interest on a HELOC
Interest rates on HELOCs are often calculated using a variable interest rate. Rates are based on a public index such as the prime rate or the U.S. Treasury bill rate. As this rate fluctuates, so will your costs.
In addition, the lender might charge a margin percentage that will add to your loan costs. For example, your line of credit might be based on the prime rate, plus a margin of 2 percentage points.
You can calculate one month’s interest on a HELOC using several steps. First, review your HELOC paperwork and look for the interest rate the lender is charging, then follow these steps:
1. Verify Your Current Interest Rate
To calculate your current interest rate, the formula is:
Current interest rate = today’s base rate + the margin
So if your HELOC is based on the prime rate plus 2 percent, and the prime rate today is 3 percent, your HELOC interest rate is 5 percent:
Current interest rate = 2 + 3 = 5.
2. Get the Daily Interest Rate
Divide your annual interest rate by the number of days in the year to get the daily interest rate:
Daily interest rate = annual interest rate ÷ 365
To calculate your daily interest on a 5-percent rate, you would use this formula:
Daily interest rate = 0.05 ÷ 365 = 0.000137.
3. Calculate Your Average Daily Balance for This Month
To calculate your average daily balance for the month, check your account and add up the daily balances of your HELOC. Divide that figure by the number of days in the month.
Average daily balance = sum of HELOC daily balances / days in the month
For example, your balance was $90,000 at the beginning of the month, but then on June 15 you borrowed another $10,000 to buy new kitchen cabinets. Your average daily balance would be calculated as follows: $90,000 multiplied by the first 14 days of the month, added to $100,000 (the new balance) multiplied by 16 (the remainder of days in the month). That figure would then be divided by 30 (the number of days in June), for an average daily balance of $95,333.33.
Average daily balance = (($90,000 x 14) + ($100,000 x 16)) ÷ 30 = $95,333.33
4. Calculate Your Monthly Interest Charged
To calculate your monthly interest charged, multiply the daily interest rate by the average daily balance for the month. Then, multiply this figure by the number of days in the month.
Monthly interest charged = (daily interest rate x average daily balance for the month) x number of days in the month
So for our example, in a month with 31 days, the monthly interest charged would be calculated as:
Monthly interest charged = (0.000137 x $95,333.33) x 31 = $404.86
If all this math leaves your head spinning and you simply want to see how much you can borrow, turn to a HELOC payment calculator to do the work for you. You can find a HELOC calculator at many bank websites.
How a HELOC and a First Mortgage Differ
HELOCs and first mortgages differ in some important ways. Borrowers use a first mortgage to buy a home. By contrast, homeowners can use a HELOC to provide the money for just about any type of spending.
With a mortgage, interest is calculated monthly. On a HELOC, interest is calculated daily, as it is on a credit card.
Payments on a fixed-rate mortgage stay the same each month. But with a HELOC, your principal balance fluctuates as you borrow money and make payments. Your payment amount can change depending on HELOC interest rate fluctuations, your credit line balance and the number of days in each month.
One advantage of a HELOC is that you only pay interest as you borrow, whereas with a mortgage you pay interest from the time the mortgage funds are released.
Here are some of the other advantages a HELOC offers:
- The approval process might be simpler. Applying for a HELOC might require less paperwork and fewer steps than applying for a mortgage.
- Borrowers do not need to reapply every time they need more money. Not having to reapply makes a HELOC a good choice for ongoing projects such as renovations.
- A HELOC can offer tax advantages over other types of loans. Talk to your tax advisor to see if this makes sense in your situation.
Although this kind of loan might seem like an obvious solution, homeowners should understand the disadvantages of a HELOC in order to make an informed decision:
- Your rate might increase. If you have a variable-rate HELOC and the prime rate goes up, your HELOC rate will go up as well. Therefore, your monthly payment will increase — even if you have not borrowed more money during the month — because you will owe more interest based on the rate increase.
- Your home might be at risk. Because a HELOC is secured against your home, not repaying the borrowed amounts and the interest can result in losing your home.
- The end of the draw period might require tough choices. When your draw period is over, your payments might increase to include principal payments, or you might owe one lump sum that must be paid in full.
If you are looking for a HELOC, sit down with a financial advisor or a trusted bank representative and discuss all aspects of the transaction in as much detail as possible. When it comes to your money and your home, you can never have too much information.