A home equity line of credit, or HELOC, can be an excellent financial tool for homeowners who want to borrow money in a cost-effective manner for home improvements, to pay for college, or finance another major purchase. However, these types of loans and their interest rates aren't well understood by many homeowners, so here's a quick overview.
A HELOC is a common way homeowners borrow against the equity they've built in their homes.
Unlike a home equity loan, a HELOC is simply a credit line that you don't have to tap into. In other words, if you obtain a $50,000 home equity loan, $50,000 will show up in your bank account, you'll owe the bank the money, and you'll pay interest on the entire balance.
On the other hand, a HELOC works more like a credit card. You open a credit line with a certain limit, but you only draw from it when you need the money. For example, you can obtain a $50,000 HELOC but only withdraw $10,000 to use toward home repairs. You'll only pay interest on the portion of the HELOC you choose to withdraw.
With a HELOC, you'll typically have a draw period, or a certain time period during which you can choose to make withdrawals, which typically lasts for up to 10 years. After the draw period is the repayment period, which generally lasts for 20 years, giving a total 30-year life span of the HELOC.
Because the HELOC is backed by your home's equity (if you don't pay, the bank can foreclose on your home), a HELOC is a secured debt, and therefore tends to have significantly lower interest rates than other types of credit lines.
Most HELOCs are set up in a way so that the maximum amount a borrower can withdraw will result in a specified upper limit loan-to-value (LTV) ratio. For most lenders, this is 80% or 85%, but other limits are possible. In other words, if your home is worth $300,000, 80% of its value would be $240,000. If you owe $200,000 on your primary mortgage, a lender using the 80% limit may approve you for a $40,000 HELOC.
Both HELOCs and home equity loans are also commonly referred to as a second mortgage. They are both backed by the equity in your home and generally are in "second lien" position, which means that if you stop paying your debts, the holder of your primary mortgage has the first opportunity to recoup their money in the event of a foreclosure.
How do HELOC interest rates work?
Unlike most purchase mortgages and home equity loans, which often have fixed rate structures, HELOCs almost always have a variable interest rate. They are typically tied to a benchmark interest rate, such as the prime rate -- for example, your HELOC interest rate might be the prime rate plus 2%. So, if the prime rate is 3%, your interest rate will be 5%. If the prime rate increases to 3.5%, your interest rate will increase to 5.5%.
There are typically minimum and maximum rates your HELOC's variable rate can be, no matter what happens with the prime rate, typically somewhere in the ballpark of 2% APR on the low end and 24% APR on the high end.
How is your HELOC interest rate determined?
There are a few factors that determine the interest rate you'll pay on your HELOC. First and foremost, just like primary mortgages, HELOC interest rates are heavily dependent on the borrower's credit score. If a bank is advertising a variable HELOC rate of 5% for borrowers with excellent credit and you're more of a "fair credit" borrower, you can expect your interest rate to be significantly higher. Your LTV ratio can also come into play, as can your income or other debts.
In addition, many banks offer introductory interest rates (also known as teaser rates or an introductory APR) with HELOCs. For example, as I'm writing this, one major U.S. bank is offering a 2.490% introductory variable APR on HELOCs for the first six months, but it will jump to a variable 5.130% after the introductory period. Introductory rates can be a great financial tool if you anticipate repaying what you borrow in a short amount of time, but if you don't, it's important to understand what your payments will be both before and after the introductory rate expires.
Many banks also offer an interest rate discount for maintaining certain relationships, or for agreeing to certain stipulations. For example, you might see an interest rate discount for agreeing to enroll in automatic monthly payments from your checking account, or if you're an existing customer of the bank. Some also give discounted rates for customers who withdraw relatively high amounts from newly opened HELOCs.
How is your HELOC interest calculated?
Unlike purchase mortgages, which calculate interest monthly, HELOCs use a daily interest calculation method, similar to that used by most credit card issuers. Known as the average daily balance method, lenders follow three basic steps:
1. Determine your daily interest rate by taking your HELOC interest rate and divide it by 365 days. For a HELOC rate of 6%, the daily interest rate would be about 0.0164%.
2. Calculate your average daily balance for the month. As a simplified example, let's say that in a 30-day month, you had a HELOC balance of $20,000 for the first 15 days and then drew another $10,000, giving you a balance of $30,000 for the last 15 days. This would give you an average daily balance of $25,000 during the month.
3. Multiply the daily interest rate by the number of months and again by your average daily balance. Continuing our example, a HELOC with a $25,000 average daily balance and a 6% interest rate for a 30-day month would accumulate about $123.28 in interest. Anything you include with your monthly payment beyond this amount will go toward paying down the loan balance.
Is HELOC interest tax-deductible?
The short answer is "it depends." Current tax law allows U.S. taxpayers who itemize deductions to deduct the interest on as much as $750,000 in qualified mortgage debt. However, only debt used to "buy, build, or substantially improve your home" qualifies.
In other words, it depends on what you use your HELOC for. If you draw $50,000 from your HELOC to put a swimming pool in your backyard, you can certainly make the case that the debt was incurred to substantially improve your home. On the other hand, if you borrowed $20,000 from a HELOC to buy your child a car, the interest on this portion of your mortgage debt wouldn't be tax-deductible.
Shop around for the best HELOC rates
Interest rates on mortgage products can vary dramatically from lender to lender, even for the same borrower. And that's especially true with HELOCs. It's not uncommon for the same borrower to get offered a HELOC with a 5% interest rate from one bank and a 6% interest rate from another.
What's more, don't forget that the maximum HELOC amounts can vary between lenders as well. Over the course of a 30-year draw and repayment cycle, a seemingly small difference in rates can translate to thousands of dollars in savings, so it's certainly worth shopping around.