Learn how a HELOC works
Many people compare a HELOC to a credit card, since it’s an open-ended line of credit that can be accessed when needed. But there are differences. Foremost is the fact that a HELOC is secured by your home, while a credit card isn’t. Among the advantages that a HELOC has over a credit card is that the amount you can tap is usually a lot greater, the interest rate is typically much lower, and any interest you pay is usually tax-deductible.
On the minus side, you may have to pay certain fees to set up the credit line. There’s also a time limit for its use, typically a 10-year draw period followed by a 15-year repayment period. Some lenders, however, insist that you pay off the entire debt, or refinance it, when the draw period ends.
But beware: HELOCs make it very easy to access credit—the lender simply sends you a checkbook or card, or allows you to make payments from an online account—so the chance of getting in over your head is high. Since repayment plans vary by lender, debt can pile up, particularly if you only pay the interest owed on your loan during the draw period. Before you borrow, calculate what your debt burden will be.
Compare the margins
The interest on a typical variable-rate HELOC is tied to the prime rate (the interest rate banks charge to large corporations for short-term loans), plus or minus a margin. Factors that affect what margin you’ll be offered include how high the prime rate is when you apply, your credit score, and the ratio of mortgage debt to your home’s value.
Compare margins before you commit to a lender. Once you’ve established a line, the interest rate will adjust on the first day of the month following a change in the prime rate. Download our free HELOC worksheet and use it to keep track of the terms offered by various lenders.
Although some lenders tease borrowers with a low fixed introductory rate, say 2.99% for six months, what really matters when comparing rates is the margin you’re being offered after that period expires. Find out if there’s a minimum draw that you must take. Also take into account any extra fees for things like early cancellation (perhaps $350-$500) or annual maintenance (up to $100).
Usually, it makes sense to choose the loan with the smallest margin, but not always. If you’re comparing a $30,000 HELOC and one lender offers you a margin of 1.1% and another 2.3%, you’ll save $360 in interest in the first year (multiply $30,000 by 0.012, the difference in the margins) if you choose the first loan—assuming you max out the line at the beginning of the year and don’t pay it back at the end. But if the first lender also charges fees, such as a $350 appraisal fee to open the line and $100 a year to keep it open, and you only borrow small amounts that you pay back quickly and so don’t accrue much in interest charges, then the second loan may be a better choice.
Borrow wisely against your home
The amount that you can borrow varies by lender. It’s tied either to the equity you have in your home—current market value minus amount owed—or a percentage of the home’s current appraised value, usually 75% or 80%. When HELOC rates are low, a borrower with a lot of equity may be able to use the line to pay off a primary loan with a higher rate of interest. But if you decide to do this, either choose a fixed-rate HELOC or be prepared for bigger payments should the prime rate rise. Naturally, you’ll pay higher interest on fixed-rate HELOCs in exchange for the predictability. Settlement costs for a typical $150,000 HELOC shouldn’t total more than $1,000, vs. $2,000 to $5,000 for a similar second mortgage.
Having a HELOC set up is good insurance for the unexpected. And because you draw out only the money you need when you need it, it may make sense if you need to borrow for a large expense like college tuition that has payments spread out over a long period of time, or a large expense that may be somewhat unpredictable like a whole-house renovation. But before you draw down your line, check other potentially cheaper sources of funds, such as credit unions or family members. Better still, if you expect that Johnny will be going to college in a few years, start saving now.