The Basics
Home Equity Lines of Credit (also known as HELOCs, which is how I’ll reference them from here on out) are mortgages, but with some key distinctions:
· During the “draw period”, you can borrow up to your credit limit, pay it down, and borrow up to the credit limit again.
· You only have to make interest payments during the draw period (but doing so will not pay down the balance).
· The interest rate is variable, normally based off of Prime
· After the draw period, you enter the “repayment period”, during which the balance must be paid off.
HELOCs are great ways to consolidate credit cards, get access to cash for home improvements, finance a new business, etc. But unless there is a long-term plan, HELOCs can cause more problems than they solve.
Here’s why:
The Variable Rate Will Change…and Go Up
Most HELOC interest rates follow the Prime rate, plus 1-2%. Prime is currently at 3.75% and has been under 4% for the last 8 years. But, Prime is increasing and will continue to do so as the economy slowly improves. Since 1990, Prime has averaged 8.75%. If your interest rate is Prime plus 1-2%, you could likely face a 10% interest rate if you hold on to your HELOC.
The Balance Isn’t Going Down
During the draw period (which is typically 5-10 years) you are only required to pay the interest accrued on the balance. While many people fully intend to pay more than the minimum (interest-only), the number of borrowers that actually pay a significant amount towards the balance during the draw period is MINISCULE. The vast majority of HELOC borrowers that start with a $25,000 balance will have a $25,000 balance 10 years later.
The “Payment Shock” Can be Substantial
After the draw period is over, borrowers enter the repayment period, which is typically 15 years. That means that not only can you not make the interest-only payment, you have to make a 15-year payment. For the typical HELOC borrower, once they start the repayment period, the payment will increase by over 125%.
Here are some examples of what normally happens to HELOC payments after the draw period (assuming a $25,000 balance):
| Interest Rate | Payment (Draw Period) | Payment (Repayment Period) | Increase In Payment |
|---|---|---|---|
| 4.00% | $83 | $185 | $101 (125%) |
If we assume that Prime reaches its 30-yr average, it gets even worse:
| Interest Rate | Payment (Draw Period) | Payment (Repayment Period) | Increase In Payment |
|---|---|---|---|
| 8.75% | $185 | $250 | $167 (200%) |
What to Do?
The best way to avoid the increased interest expense and “payment shock” of a HELOC is consolidate it into fixed-rate 1st mortgage. Here’s why this helps:
· The rate will be fixed, and likely lower than your HELOC rate.
· The balance will actually paid off!
· The payments will stay the same and be substantially lower what they would be during the repayment period.
If the same borrower with the $25,000 HELOC balance consolidated that into a fixed rate 30-yr loan, the payment for that balance would only be $119/month.
We are in a unique market here in Utah. Home values have finally re-achieved their peak from 2006, but interest rates are still historically low. That means that this is the perfect opportunity to “fix” your HELOC problem.
Call us today to see what your scenario would look like.
