A home equity line of credit (HELOC) provides homeowners with a line of credit that they can draw on up to the amount approved by the lending bank. In that respect, a HELOC is similar to a conventional credit card. The amount of the loan is based on the equity in your home and your credit history. Interest rates are certainly important in determining the best HELOC for your particular situation, but you should consider many other factors as well.
A bank HELOC's term is divided into two periods: the draw and repayment periods. The draw period is the time during which the borrower can access the line of credit to make purchases, which typically lasts five to ten years. You'll only be charged for the interest on the funds that you actually borrow during the draw period.
The repayment period begins after the draw period ends, at which point the borrower must begin making monthly payments on both the principal borrowed and the interest on that principal. Lenders' terms vary greatly in this regard, so it's important to know exactly how they define the draw and repayment periods.
Solidify your finances
The value of your home equity is the primary factor that lending banks consider when deciding whether to approve HELOC applications. Nonetheless, your overall financial picture will still need to be as solid as possible to maximize your chances of approval. Additional factors that lenders look at include your credit score and debt-to-income ratio, so improving your credit score and paying off debt before applying can make a major difference.
Learn about the current market
Interest rates on HELOCs are generally based on current market conditions, so they can vary considerably over time. When rates are low, it could be a bad time to get a variable rate loan because your payment could go up overtime, whereas locking in your rate can provide you with stable payments over the life of the loan.
During periods of high rates, you may want to refrain from getting a loan at all. If you do need a loan, getting a HELOC can ensure you get a lower rate than other kinds of unsecured debt.
Beware of teaser rates
A suspiciously low rate on a HELOC is likely to be a teaser rate used to attract potential borrowers. Such a rate will usually increase dramatically after a short introductory period. Another confusing technique is to advertise only the interest rate for the HELOC's benchmark, but later add the lender's margin after the loan is approved.
Assume for this example that a bank bases its HELOC rate on a benchmark such as the prime lending rate. That rate happens to be 3% at the time the bank posts its advertisement, so the listed rate is 6%. However, the bank also requires a margin of 2%, meaning you would actually pay 8% for that HELOC. These details should be explained in the fine print, which can be easy to miss if you focus only on the advertised rate.
Consider a conversion clause
Bank HELOCs typically have variable rates, meaning the interest rate can change over the term of the loan. However, some banks may allow you to change your interest rate from variable to fixed, typically during the draw period. This option, formally known as a conversion clause, is advantageous when interest rates are expected to increase, allowing you to lock in a lower fixed rate. Lending banks also may allow you to switch back to a variable rate when rates start falling.
Look for additional fees
Banks often use additional fees to compensate for an unusually low interest rate and they could charge fees if you fail to maintain a minimum balance on your line of credit.
An inactivity fee is another way for banks to make money on a HELOC; it is assessed when you fail to draw on the account within a prescribed period of time. While it is not a fee per se, some lenders will require you to make a minimum draw upon closing, in which case you could be borrowing money that you don’t need at the time.
Watch out for penalties
Additional costs of HELOCs include prepayment and early closure penalties. A prepayment penalty occurs when you pay off the loan balance before it's actually due. This is uncommon for HELOCs, but you should still check for it in your terms.
Early closure penalties are a form of prepayment penalty that can be levied if you close your HELOC credit line early in the draw period, before the bank has had a chance to recoup some of the closing costs that it may have waived to get your business.
Beware of balloon payments
A HELOC with a balloon payment clause requires you to pay the entire balance at the end of the draw period. You should consider such a HELOC only if you maintain assets that are sufficient to cover what you draw from the HELOC, in which case you would probably be better off using those reserves to pay for unexpected expenses rather than paying the costs of a HELOC. This could help explain why balloon payment clauses have become unusual in the lending industry.
Develop a sound financial policy before shopping around for a HELOC. This policy should include factors such as what you will use it for, how and when you plan to pay it back, and who will have access to the account. Establishing a repayment plan in advance is particularly important in minimizing the costs of a HELOC. A HELOC charges interest only on what you borrow, so you should use this to your advantage by drawing funds only to pay for projects for which you clearly have a need.
Disclaimer 1The Figure Home Equity Line is an open-end product where the full loan amount (minus the origination fee) will be 100% drawn at the time of origination. The initial amount funded at origination will be based on a fixed rate; however, this product contains an additional draw feature. As the borrower repays the balance on the line, the borrower may make additional draws during the draw period. If the borrower elects to make an additional draw, the interest rate for that draw will be set as of the date of the draw and will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. Accordingly, the fixed rate for any additional draw may be higher than the fixed rate for the initial draw.