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October 20, 2003
"I have been advised to refinance
with a HELOC rather than with a standard mortgage. Could you explain the
difference, and why one might be better than the other?"
HELOC stands for home equity line of credit,
or simply "home equity line." It is a loan set up as a line of credit
for some maximum draw, rather than 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.
HELOCs are convenient for funding
intermittent needs, such as paying off credit cards, making home improvements,
or paying college tuition. You draw and pay interest on only what you need.
Upfront costs are also relatively low. On a
$150,000 standard loan, settlement costs may range from $ 2-5,000, unless the
borrower pays an interest rate high enough for the lender to pay some or all of
it. On a $150,000 HELOC, costs seldom exceed $1,000 and in many cases are paid
by the lender without a rate adjustment.
Most HELOCs are second mortgages. An
increasing number, however, are first mortgages, as yours would be if you used
it to refinance your existing first mortgage. Using a HELOC as a substitute for
a first mortgage is risky, for reasons discussed in a moment.
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 .005, 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.
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 5 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 to 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.
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.
Note: Some HELOCs are convertible into
fixed-rate loans at the time of a drawing. This is a useful option for borrowers
who draw a large amount at one time.
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, as recently as 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 puts 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%.
Don�t compare the APR on a HELOC with the
APR on a standard loan because they mean different things. The APR on a HELOC is
the interest rate, period. Among other things, it does not reflect points or
other upfront costs, as the APR on standard loans does. Requiring lenders to
show the interest rate on a HELOC twice is a strange way to protect borrowers,
but there it is.
Copyright Jack Guttentag 2003
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