March 22nd, 2018 6:39 AM by Jackie A. Graves, President
Home Equity Line of Credit (HELOC) is a type of adjustable rate home loan that
functions much like a credit card because you can draw from it and pay it down
in the same manner. Let’s take a closer look so you can determine if a HELOC is
right for you.
HELOC is often a second mortgage, but it doesn’t have to be. If you owed
nothing on your home, you could get
a HELOC as a standalone first mortgage.
example, if you owned a $400,000 home free and clear but wanted a safety net,
you could open a HELOC for $200,000. In this case, the HELOC would be
considered a first mortgage (because there is no other mortgage on the home),
but you’re not required to take out $200,000.
lender provides you a checkbook and/or a credit card with your HELOC, and you
can “draw” on that HELOC when needed. You will not be required to make payments
on the HELOC until you draw on it using your HELOC checkbook or credit card. If
you never drew on the $200,000, you’d never have a payment—but you would have
some closing costs for putting the HELOC in place to begin with.
HELOC concepts also hold true if you’re using a HELOC to buy a home. Suppose
you’re buying a home for $400,000 with 10 percent down. You could get a first
mortgage for 80 percent of the purchase price (or $320,000) and a HELOC second
mortgage for 10 percent of the purchase price (or $40,000).
this example, you’d have a payment on the $40,000 because you’d be drawing the
full $40,000 at closing. But if you paid the $40,000 down to $30,000, your
payment would then be based on $30,000.
Learn more about reasons to use a
rates are based on two components: a set base rate called a “margin,” plus a
fluctuating rate called an “index.”
index for HELOCs is the Prime Rate, which is a rate that is tied to the Federal
Reserve System’s interest rate decisions. When you hear about the Fed moving
rates, they’re moving an overnight bank-to-bank lending rate called the Fed
Funds Rate. Fed Funds isn’t a consumer rate, but it does serve as a benchmark
for consumer rate levels, and the Prime Rate index that HELOCs are tied to is
the perfect example. The Prime Rate is comprised of the Fed Funds Rate plus
in 2008 when the financial crisis was escalating, the Fed cut the Fed Funds
rate all the way down to 0.25 percent by January 2009. As such, the Prime Rate
was 3.25 percent (which is Fed Funds plus three percent). It stayed that way
until December 2015, when the Fed finally hiked the Fed Funds rate by .25
percent to .5 percent, and then Prime became 3.5 percent.
will move up or down in this manner as the Fed continues to adjust Fed Funds.
margin for a HELOC is based on your credit quality and total equity in the home
after the HELOC is in place. It’s the additional premium you’d have on the rate
for the additional risk the lender is taking based on your profile.
example, many lenders will only allow the combined first mortgage plus HELOC
amounts to go up to 90 percent of a home’s value. If you’re getting a HELOC
that’s taking you up that high, you’re going to have some sort of a margin on
top of Prime.
the margin in this example is 1.5 percent, then based on today’s Prime Rate of
3.5 percent, your total HELOC rate is Prime plus 1.5 percent, or 5 percent.
Learn more about how to get the best
this example, your payment would be calculated using a 5-percent rate on the
outstanding balance of your HELOC. So if you had paid your $40,000 loan down to
$30,000, you’d only be charged 5 percent on the current balance. This is
different from a typical first or second mortgage, where the payment is always
based on the original balance until you pay the loan off.
general, your HELOC payment will fluctuate based on your loan balance and on
your rate moving in line with Prime Rate movements.
there is also a feature of HELOCs called a “fixed rate draw” or “fixed rate
advance” which enables you to draw a portion of the available HELOC balance as
a fixed rate.
is handy for larger expenditures such as a home improvement project that you
don’t intend to pay off right away. You can use the fixed rate draw to fix that
portion of your HELOC so you’re protected if rates rise later. But rate levels
for fixed rate draws can often be higher than the index plus margin rate at the
time you take them.
you have to work with your mortgage advisor to determine whether a fixed rate
draw is the best choice for your time horizon, and where rates are in the
current economic cycle.
though your HELOC payment is usually just the interest (rather than principal
plus interest), HELOCs will use a higher payment to qualify you to account for
future fluctuations in the rate that could hike your payment.
lender has a slightly different qualifying formula, but a common formula is
that a bank will calculate a payment using a 20-year principal plus interest
payment assuming the HELOC is fully drawn.
will result in a significantly higher payment than you’ll actually be required
to make, and might present qualifying challenges.
this is the case, a HELOC might not work for you. Then you can get a traditional
second mortgage, which is often called a home equity loan.
home equity loan is a traditional principal-plus-interest payment, and there’s
no ability to draw from it. If you were buying the home above with a fixed rate
home equity loan instead of a HELOC, you’d get a $40,000 second mortgage, and
the payment would always be based on what it was at closing.
payment will be slightly higher than a HELOC’s index plus margin today, but
that’s because the Prime Rate for HELOCs is still abnormally low.
your loan advisor to present HELOC and home equity loan options for you to
compare side by side. Learn more about HELOC
vs home equity loans.
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