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Home Equity Line of Credit means a mortgage that was set up as a line of credit against which a borrower can draw up to a maximum amount, as opposed to a loan 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. Most HELOCs are second mortgages and are used to fund intermittent needs, such as paying off credit cards, making home improvements, or paying college tuition. However, an increasing number of HELOCs are first mortgages used to refinance an existing first mortgage. Interest Calculated Daily: 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 .5, 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. Draw Period and Repayment Period: 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 five 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 on the 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. Low Up-Front Cost: A major advantage of a HELOC over a standard mortgage in a refinancing is a lower upfront cost. On a $150,000 standard loan, settlement costs may range from $2,000 to $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 credit line, costs seldom exceed $1,000 and in many cases are paid by the lender without a rate adjustment. High Exposure to Interest Rate Risk: 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. 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, in 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 in 2003 put 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%. Shopping for a HELOC: Shopping for a HELOC is simpler than shopping for a standard mortgage, if you know what you are doing. 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 one to six 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 Margin: 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 three 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. Other HELOC Features: 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. Up-front 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 three years. Truth in Lending (TIL) on a HELOC: The required TIL disclosure on HELOCs is a travesty. Borrowers must be given an APR, but it is the same as the interest rate. Among other things, it does not reflect points or other upfront costs, as the APR on standard loans does. 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. Shopping 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. Up-front lender fees 6. Up-front third party fees 7. Annual fee 8. Cancellation fee
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