Most homeowners use a home equity line of credit (HELOC) when they need to make improvements to the home. It makes sense to leverage the untapped value to increase the home’s value for the long term. For many years, homeowners misused these lines of credit for paying off smaller bills and trivial expenses. Over time, using an equity line this way is a recipe for financial disaster.
How a HELOC Works
Home equity plans often set a fixed time while you are allowed to borrow money, typically ten years. When this "draw period" ends, borrowers may be offered a renewal of the line of credit. Plans that do not offer renewals will either demand full payment at the end of the draw period or allow repaying over a set time, usually a ten-year "repayment period."
To illustrate, consider our homeowner Beth. She owns her home outright, but it needs some repairs. She has many options available, but has decided to go with a HELOC. This loan has cheaper closing costs and the most flexibility. Now she can be sure she has enough money to cover all the necessary repairs.
Shopping for a HELOC
But shopping for a HELOC is challenging. Lenders will sometimes offer temporarily discounted rates, which then spike after six months. In addition, the margin on a HELOC is different for each lender. The margin is the additional interest charged above the prime rate that sets the HELOC rate.
For example, if Beth secured a loan with a starting rate of 5% for 6 months that was “based on prime,” she might assume that because her starting rate was locked in at 1% above prime that her ongoing margin would remain 1%. But “based on prime” does not mean that the regular interest rate will be set the same way as the introductory rate. It only describes the relationship of the changing margin to prime. The margin could go up to 5% for a total rate of 9%!
That’s why Beth should be careful to ask about the margin on the loan. She should ask for the terms in writing, stating both the introductory rate and the margin. She should also find out if there is a minimum draw at closing and how much that draw would be. Many loans require borrowers to take out money right away so that the lender can start earning interest right away.
Some loans also carry a required average balance. They might charge upfront lender fees, third-party fees, cancellation fees and annual fees. Beth should make sure she has all of these fees in writing, even just to say they do not apply to the loan, before she signs on for any home equity line of credit.
By carefully choosing her lender, Beth was finally approved to borrow as much as $100,000 for her home repairs. She chose a loan that would let her convert to a fixed pay period after the draw period. She had the introductory rate, margin and all fees in writing before she signed on.
Choices After the Draw Period
After two years, Beth found that the full cost of repairs came to $65,000. She no longer needed the draw period on this loan, which was open for another eight years. Instead of taking chances with variable rates, she decided to refinance the loan into a fixed rate 15-year mortgage that she will try to pay off within ten years.