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Home Equity Line Of Credit Heloc


Definition of "Home Equity Line of Credit (HELOC)"

A mortgage set up as a line of credit against which a borrower can draw up to a maximum amount, as opposed to a loan for a fixed dollar amount. Interest Calculated Daily: 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 .5, multiplied by the loan balance at the end of the preceding month. If the balance is $100,000, the interest payment is $500. Draw Period and Repayment Period: 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 five 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 on the 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. Low Up-Front Cost: A major advantage of a HELOC over a standard mortgage in a refinancing is a lower upfront cost. On a $150,000 standard loan, settlement costs may range from $2,000 to $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 credit line, costs seldom exceed $1,000 and in many cases are paid by the lender without a rate adjustment. High Exposure to Interest Rate Risk: 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. 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 in 2003 put 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%. Shopping for a HELOC: Shopping for a HELOC is simpler than shopping for a standard mortgage, if you know what you are doing. The major reason is that important features are the same from one lender to another. The Margin: The critical feature of a HELOC that is not the same from one lender to another, and which should be the major focus of smart shoppers, is the margin. This is the amount that is added to the prime rate to determine the HELOC rate. Other HELOC Features: If the HELOC will be used to meet future contingencies rather than to refinance an existing mortgage, the shopper needs to know whether there is a minimum draw at closing, or a minimum average loan balance. Lenders don't make any money unless the HELOC is used, but they are not always forthcoming about this. Borrowers who are uncertain about future usage don't want to be forced to borrow money they won't need. Truth in Lending (TIL) on a HELOC: The required TIL disclosure on HELOCs is a travesty. Borrowers must be given an APR, but it is the same as the interest rate. Among other things, it does not reflect points or other upfront costs, as the APR on standard loans does. The borrower described above was given an APR of 4.5% early on, and when his rate jumped to 9.5% he was told that his new APR was 9.5%. TIL does not require disclosure of the margin.



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