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Home Equity Line Of Credit
A home equity line of credit, HELOC in short, is a mortgage set up as a line of credit resembling an overdraft for borrowers to draw funds upon when necessary.
Among the various ways for a home owner to tap on the home equity accumulated in the house, a home equity line of credit stands out from the typical second mortgages and regular home equity loans for it’s uniqueness.
The uniqueness have nothing to do with zero interest rates or free credit. That would more than being unique. It would be magical.
It is different from the rest because it allows the borrower to make the use of readily available credit on a as-needed and impromptu basis.
For example, for a standard mortgage term loan of $100,000, the total amount of $100,000 is disbursed in full upon closing unless it is a pre-arranged staggered payment structure which is common for yet-to-complete new homes.
Either way, the loan amount is disbursed as cash for payment to the seller.
Whereas for a HELOC, a borrower might be given a credit line of $100,000 which he can withdraw on at any time during which the account is active by writing checks, using credit cards, via ATMs.
In effect, this means that the borrower will not incur interest charges until he starts using money from the account.
In contrast, a borrower will immediately incur interest charges as soon as a regular mortgage is closed and disbursed.
While most HELOCs are second mortgages, they are often secured against unencumbered property as well.
How interest on HELOCs are calculated
Because the amount of funds used on a HELOC can vary day to day, it makes sense that the interest charges on these facilities are calculated on a daily basis rather than monthly.
For example, if the interest is 5%, the daily interest rate would be:
0.05/365 = 0.000137
If the daily average balance on the account is negative $50,000 on a particular month, then the daily interest charge would be:
0.000137 x $50,000 = $6.85
On a month with 30 days, the total interest charge for the month would be $205.50. $212.35 for a month consisting of 31 days. And $191.8 for a month with 28 days.
In contrast, a regular home loan with a simple interest of 5% would have a monthly interest rate of:
0.05/12 = 0.00417
With a loan balance of $50,000, the monthly interest charge would work out to be:
0.00417 x $50,000 = $208.50
This would be the figure no matter how many days the month consist of.
Draw and repayment periods
To deter borrowers from using HELOCs like regular home loans, draw periods are included in them stating the time period in which the borrower can draw upon the account.
During this time frame, the borrower will only be required to repay loan interest to the account.
While the credit limit is often indicated in the account, lenders sometimes do allow account owners to draw more funds exceeding the limit.
The excess will of course, be charged with a higher interest.
And because the facility was probably approved with a low loan-to-value (LTV) secured to the property, lenders are usually very comfortable with such events as they have their risks covered with the appraised value of the property in mind.
Together with the draw period clearly indicated in the mortgage contract, a repayment period would also be specified.
This basically states the period in which the borrower has to repay the loan principal or remaining balance in full. The latter even can occur when borrowers repay more than the required payments during the draw period, essentially reducing the outstanding amount.
The repayment structure is usually calculated by dividing the balance amount by the number of months contained in the repayment period.
For example, if the repayment amount is $60,000 over the course of 24 months, then the monthly repayment required until the end of the repayment period would be:
$60,000/24 = $2,400
However, it’s not uncommon to find lending terms that require the borrower to repay the outstanding balance in full upon the expiry of the draw period.
At this point, the borrower has to find the funds to settle the debt or find another lender willing to refinance it.
As sure as the sun rising from the east, you can expect a lender to charge significant upfront fees for any types of loan products.
This is no exception.
The silver lining is that upfront costs for HELOC is generally accepted to be lower than that of a typical new loan or refinance.
There are also occurrences where homeowners claim to have the fees waived out of good faith.
While these stories might be true, let’s talk about why lenders are willing to do this in certain circumstances.
These full waivers are most commonly found in cases where unencumbered property is used as collateral. This gives the lender the luxury of placing a first priority lien on the the property.
When you consider that the borrower of the HELOC might or might not use the facility at all. And that even if he used it, he might use only a small portion of the credit limit as people who go for such facilities are generally risk-adverse. Add in the fact that the LTV could be just a fraction of the real estate’s market value. Then the closing of the loan allows the lender to strategically make a full claim on the property with little actual capital.
While the odds of the deal going through foreclosure with the lender acquiring the property at a low price is remote, when we factor in the small required investment against the potentially huge gains, then the logic behind why lenders might be receptive to such generosity can be better understood.
However, don’t expect favors in a no doc HELOC.
Interest volatility risks
Even though all HELOCs are structured to be adjustable rate mortgages (ARM), they are not created equal with most regular housing loans available to the public.
This is because the index rate used to make up a significant portion of the interest rate is almost always the prime rate. Whereas regular home loans commonly incorporate indices like LIBOR and treasury rates that are lower than prime rate.
Good luck trying to negotiate for fixed rates as it is as good as impossible.
With luck on your side, you might be able to obtain an introductory rate that holds for a few months. After which it would float and switch to an all out ARM.
The implications of this is that a borrower would be undoubtedly exposed to volatile interest rate fluctuations.
The notion that prime rates are stable is the type of folklore that should be buried together with the financial crisis of 2008.
Should the prime rate encounter a hike on the very last day of the month, the new rate would be effective on a HELOC on the first day of the following month.
On the contrary, a regular ARM would have adjustment intervals and possibly various adjustment ceilings that keep interest rates in check.
While a home equity line of credit might also have an maximum interest rate limit, it is always higher than what we find on regular mortgages.
Do note that even though home equity lines of credit can appear inexpensive on the surface as borrowers don’t incur interest charges unless they use the facility, lenders are know to sell them in higher interest rates to make up for the potential shortfall in revenue.
Choosing a HELOC
One advantage that HELOCs definitely have over regular loans is that comparing them is much easier because their features consist of the same variables from lender to lender.
Because they are all pegged to the prime rate, it is so easy to compare the interest of one against another.
Regular home loans can have a diverse variety of different index rates that make up their interest rates. Making it difficult and tedious to compare and comprehend.
This means that the main differentiator of HELOCs offered by different lenders are the margins and closing costs.
Some fixed fee expense items might include:
- Origination fee
- Facility fee
- Annual fee
- Application fee
They are usually inexpensive when compared to those found on traditional home loans.
While the non-cost features of the facility from different lenders should also be contemplated:
- Introductory period of preference rates
- Draw period
- Repayment period
- Minimum draw
- Average balance requirement in order to avoid fall below fees
Then there are the costs of credit:
- Index rate
The margin is a particular area of concern.
So remember to explicitly ask what is the prime rate and margin that a lender is charging.
Never assume that the difference between the interest charged and the prime rate is the margin.
Sometimes when introductory rates are built into a HELOC, borrower might make the mistake of assuming the introductory rate consist of the prime rate plus margin, effectively determining the margin of the facility.
Then after the introductory period, the true margin is revealed… which is already too late to cry for help.
For example, if the prime rate is 4.50% and the introductory rate is 5%, borrowers might assume the margin is 0.50% and signed up for it thinking they’ve got a steal. But what they don’t realize (because they didn’t ask) is that the true margin is 4% and that the introductory rate does not consist of the prime rate at all. This means that the rate after the introductory period is a whopping 9%!
Home equity loan
As you can see, a HELOC can be more cost effective for a borrower.
But this is only true if the borrower uses it sparingly.
If you already know that you will need a specific amount of money for some reason the foreseeable future, a typical home equity loan that gives you a lump sum can be a cheaper alternative.
This is because HELOCs have higher interest rates than term loan by default.
If $100,000 is borrower via both a home equity loan and a HELOC over 10 years, the one that pays more interest charges will be the latter.
So if you are already certain that you will need a specific amount of funds, do seriously look into the feasibility of a home equity loan.
You might end up saving thousands of dollar by choosing it over a HELOC.