Home equity loans and home equity lines of credit (HELOCs) can be powerful tools for financing big projects without incurring high-interest credit card debt. But when interest rates are unstable, adjustable-rate products like HELOCs are a bit trickier. How do you determine the right time to apply for a HELOC and what should you look for in one?
- Home equity lines of credit allow you to borrow against the equity in your home.
- You only pay interest on the amount you actually borrow, not on your full credit limit.
- HELOCs have variable interest rates, tied to an index such as the prime rate. When that rate rises, yours will, too.
- To reduce your risk, ask the lender if there's an option for converting to a fixed rate in times of high interest.
What Is a HELOC?
If you're a homeowner who has accumulated some equity in their home, you may have significant borrowing power. A home equity line of credit (HELOC) can allow you to borrow money at a rate that hovers slightly above regular mortgage rates—and far lower than the rate on a typical credit card or personal loan.
Though home equity loans have a fixed interest rate and are paid back through equal installment payments, HELOCs have an adjustable or variable interest rate, tied to an index such as the prime rate. Though this can be an advantage when interest rates are low, you could be subject to a much higher interest rate over the life of the loan if the index rises in the future.
On top of the prime rate or other index, lenders add a margin, or markup, such as 2 percentage points. So if the prime rate, for example, is 4%, they might charge you 6%. If it rises to 5%, your rate might rise to 7%, and so on.
HELOCs typically have a draw period of 10 years, during which borrowers can make only interest payments. After that 10-year period ends, the borrower must pay both interest and principal until the loan is completely paid off. Unless they plan ahead, borrowers can sometimes be surprised by the amount of those payments, and they may face difficulties in repaying the loan.
How Do HELOC Interest Rates Change?
The prime rate, the index that many HELOC lenders use, is based on the federal funds rate, which can change every six weeks. By federal law, HELOC contracts must have a cap on how high your interest rate can rise over the life of the loan. They may also have a floor beneath which your interest rate can't drop. Some states also set limits on how high interest rates can rise.
Many lenders offer a low introductory rate, often called a teaser rate, for a certain period of time. If you're shopping for a HELOC, you'll want to make sure you know how long that rate will be in effect before rate adjustments can begin.
With a HELOC, you don't have to borrow your full credit line, and you'll be charged interest only on the portion you do borrow. In times of interest rate volatility, borrowing no more than you absolutely need can help keep your payments more manageable.
How to Assess Risk for HELOCs
In a volatile interest rate climate, there is the potential for both positive and negative interest rate changes. A HELOC may still offer a lower interest rate than most consumer credit cards, which also have variable rates and no federal law that they carry caps, except for some members of the military.
At the same time, a HELOC comes with more risk. If interest rates skyrocket and you can't keep up with your payments, the lender could foreclose on your home and you could lose it.
If you're using the HELOC for home improvements that will add to your home's equity, it might be worth risking the consequences of a potentially higher interest rate. If you're using it for a vacation, you might want to reconsider.
Another way to mitigate the risk is to see if your lender offers the option to convert some or all of your HELOC to a fixed rate. Though not every lender allows this, it could be a smart move if it's available.
Is There a Required Minimum Balance on a HELOC?
That depends on the lender and the terms of your contract. Some HELOCs require that you maintain a certain balance, while others don't.
Do HELOCs Have an Annual Fee?
HELOCs are revolving credit lines, so it is common for a lender to charge an annual fee for keeping the line open, similar to many credit cards.
Can I Pay Off My HELOC Early?
The rules on early payoffs can vary from lender to lender. Some lenders may require you to maintain the account for a certain period of time, or they may allow an early payoff with a penalty fee. Check your HELOC documents or ask your lender to confirm. Sometimes paying the HELOC off early can be worth it, even if you have to pay an extra fee to do so.
The Bottom Line
When interest rates are volatile, borrowing can be tricky. A fixed rate will insulate you from rising interest rates, but if you lock in a fixed rate when rates are high, you may miss out when they come back down. Variable home equity lines of credit are subject to interest rate fluctuations, although borrowers are protected somewhat by caps on how high their rates can rise over time. The best course is to borrow no more than you need and to consider whether you'd be able to keep up with the payments if your rates rise substantially. Your home may depend on it.