HELOCs and home equity loans can be effective tools for funding significant improvements without accruing high-interest credit card debt. However, HELOC rates and other adjustable-rate products are more difficult to use when interest rates are erratic. When should you apply for a HELOC, and what qualities should you seek for in one?
How Do HELOCs Work?
If you own a property and have built up some equity in it, you may be able to borrow quite a large amount of money. You could be able to get home equity line of credit (HELOC) at a rate that is far less expensive than the rate on a conventional credit card or personal loan, and just slightly more than standard mortgage rates.
Comparable to a credit card account, a home equity line of credit gives you access to a revolving credit line. But unlike a credit card, it uses the value of your house as security. While HELOCs have an adjustable or variable interest rate that is based on an index like the prime rate, home equity loans have a fixed interest rate and are repaid in equal monthly installments.
Although this may be advantageous when interest rates are low, if the index increases in the future, you may be subject to a considerably higher interest rate over the course of the loan.
Lenders add a margin or markup, such as a 2 percentage point markup, atop of the prime rate or another index. For example, they may charge you 6% even if the prime rate is 4%. Your rate might increase to 7% from 5%, and so on.
Borrowers may only make interest payments during the 10-year draw period of a HELOC. The borrower must continue making principal and interest payments after the first 10-year term expires until the loan is repaid in full. Borrowers can be surprised by the size of such installments if they don’t budget ahead, and they might have trouble paying back the loan.
How Do Interest Rates on HELOCs Vary?
The federal funds rate, which is subject to change every six weeks, is the basis for the prime rate, the index that many HELOC lenders utilize. HELOC contracts are required by federal law to feature a limit on how much your interest rate may increase over the course of the loan. Additionally, they can have a floor below which the interest rate cannot decrease – some governments place restrictions on how high interest rates could go.
For a limited time, many lenders provide a low introductory rate, sometimes known as a teaser rate. When looking for a HELOC, it’s important to understand how long the teaser rate will be in place before they begin increasing the interest rate.
How to Evaluate the Risk of HELOCs
Both negative and positive interest rate changes are possible in an environment of fluctuating interest rates. A HELOC may nevertheless have a lower interest rate than the majority of consumer credit cards, which generally have variable rates and are not required by federal law to have limitations – with the exception of select military personnel.
Be aware that a HELOC does carry extra risk at the same time. The lender may foreclose on your house and you may lose it if interest rates soar and are unable to make payments. It can be worthwhile to take a chance on the potential of possible higher interest rates if you’re using the HELOC for home upgrades that will increase the value of your house. However, you may want to give it further thought if you’re utilizing it for a trip.
Another strategy to reduce risk is to check and see if your lender gives you the opportunity to change a portion or all of your HELOC to a fixed rate. Although not all lenders permit this, if it is possible it might be a wise choice.
Is There a Minimum Balance Required on a HELOC?
That is dependent on your contract’s terms and the lender. You must keep a particular balance with some HELOCs, but not others.
HELOCs: Are There Annual Fees?
Due to the fact that HELOCs are revolving credit lines, annual maintenance fees are frequently assessed by lenders, just like with many credit cards.
How Early Can I Pay Off My HELOC?
Lenders may have different early payout policies. Some lenders could demand that you keep the account open for a specific amount of time or might permit an early payoff with penalties. Check your HELOC paperwork or get confirmation from your lender.
Borrowing can be challenging when interest rates are erratic. A fixed rate will protect you against rising interest rates, but if you lock one in at a high rate, you will risk losing out when rates decline. Interest rate changes can affect variable home equity lines of credit, although borrowers are somewhat shielded by limitations on how much their rates can increase over time. The best course of action is to borrow only what you need and to think about whether you’d be able to make the payments if your rates significantly increased-it can be crucial for your house.