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.
No, shopping for a HELOC is very different from shopping for a standard mortgage. In most respects, it is simpler, if you know what you are doing. A HELOC is a line of credit, as opposed to a loan for a specified sum, and it is always adjustable rate. The bad news about that, which I discuss in What Is a HELOC, is that HELOCs provide borrowers with much less protection against interest rate increases than standard ARMs. The good news is that HELOCs are easier to shop for. The major reason is that important features are the same from one lender to another.
*The interest rate on all the HELOCs is tied to the prime rate, as reported in the Wall Street Journal. In contrast, standard ARMs use a number of different indexes (LIBOR, COFI, CODI, and so on) which careful shoppers have to evaluate.
*The interest rate on the HELOCs adjust the first day of the month following a change in the prime rate, which could be just a few days. (Exceptions are those HELOCs with an introductory guaranteed rate, but these hold only for 1 to 6 months). Standard ARMs, in contrast, fix the rate at the beginning for periods ranging from a month to 10 years.
*The HELOCs have no limit on the size of a rate adjustment, and most of them have a maximum rate of 18% except in North Carolina, where it is 16%. Standard ARMs may have different rate adjustment caps and different maximum rates.
*The critical feature of a HELOC that is not the same from one lender to another, and which should be the major focus of smart shoppers, is the margin. This is the amount that is added to the prime rate to determine the HELOC rate. Many if not most lenders do not volunteer the margin unless they are asked. Here is what can happen when you don’t ask. Borrower X, who provided me with his history, was offered an introductory rate of 4.5% for 3 months. He was told that after the three months the rate "would be based on the prime rate." At the time the loan closed, the prime rate was 4%. Three months later, the prime rate was still 4%, but the rate on his loan was raised to 9.5%. It turned out that the margin, which the borrower never asked about, was 5.5%!
WARNING: Do not assume that the difference between your HELOC start rate and the prime rate is the margin. It may or may not be. Ask. Bear in mind, as well, that the margin varies with credit score, ratio of total mortgage debt to property value, documentation and other factors. You need the margin on your deal, not the margin they are advertising which is their best deal.
Truth in Lending (TIL) on a HELOC is a travesty. It requires that borrowers be given an APR, which is the same as the interest rate. The borrower described above was given an APR of 4.5% early on, and when his rate jumped to 9.5% he was told that his new APR was 9.5%. TIL does not require disclosure of the margin. If the HELOC will be used to meet future contingencies rather than to refinance an existing mortgage, the shopper needs to know whether there is a minimum draw at closing, or a minimum average loan balance. Lenders don’t make any money unless the HELOC is used, but they are not always forthcoming about this. Borrowers who are uncertain about future usage don’t want to be forced to borrow money they won’t need. Last and least important are the fees. Upfront fees are the same types as on standard mortgages, except that HELOC lenders seldom charge points, and third party fees tend to be small and are often paid by the lender. In addition, there are some uniquely HELOC charges that you should factor in. These include an annual fee, usually $25-$75 and often waived the first year; and a cancellation fee, perhaps $350-$500, which is usually waived if the account stays open for 3 years.
Here is your checklist: make sure the figures you get apply to your deal.
1. Introductory rate and period
2. Margin
3. Minimum draw
4. Required average balance
5. Upfront lender fees
6. Upfront third party fees
7. Annual fee
8. Cancellation fee
Lone Star Funding Partners, LLC
281 852-7836
Humble, TX 77346