8 Surprising facts to know before getting a HELOC

Kate Gillan | Citizens

You might have seen the headlines — as home values continue to rise, home equity lines of credit (HELOCs) have grown in popularity. HELOCs provide flexible financing at an interest rate often lower than unsecured loans such as a personal loan or credit card. A HELOC is sometimes referred to as a “second mortgage,” or a “lien,” and is generally used to finance something major such as a home improvement project, consolidating high-interest debt, tuition costs and more. And while interest rate pauses and hikes can sometimes leave us feeling unsure whether now is the best time for a HELOC, knowing the ins and outs can be helpful when deciding. They come with some risks, so it’s important to consider some surprising and hopefully helpful facts surrounding a HELOC so you can make the best decision for your individual situation.

Here are eight surprising facts about HELOCs:

1. Many factors influence HELOC rates

While different institutions may have varying factors, usually the rate will be based off your line amount, credit score, lien position and state taxes. Most lenders will cap your total borrowed amount, inclusive of any existing mortgage, at around 80%-85% of your home’s value. When it comes to interest rates, HELOCs usually have a higher interest rate than a first mortgage due to risk, but offer lower rates than unsecured borrowing options such as personal loans or credit cards. Here's how each factor affects the rate of your HELOC:

Line amount: The size of your line amount could have an impact on your APR (annual percentage rate). You can generally borrow up to 80%-85% of your equity, though this varies by lender and depends on a range of other factors.

DTI ratio: Your debt-to-income ratio, or DTI, can play a large role in your ability to qualify for a HELOC. It’s the percentage of your gross monthly income that goes toward paying your monthly debts, and helps lenders determine whether you can afford to take on more debt. It’s calculated by dividing your monthly debts, including a new HELOC payment, by your monthly gross income.

Credit score: A favorable credit score of at least 680 is ideal to meet most lenders’ approval requirements, and a higher credit score will likely earn you a lower APR.

Lien position: For borrowers with an existing mortgage, their HELOC will likely fall into second lien position (the first mortgage being in first position). Borrowers without a mortgage (meaning you’ve paid off your home, bravo!) whose HELOC can be in a first lien position, may be privy to a more favorable rate.

State taxes: Some states impose a mortgage recording tax, and in turn some lenders may account for this tax in your APR. If your property is in one of these states, your APR could be higher than it would be in a state without a mortgage recording tax.

2. The interest rate and APR aren’t always the same

You may have seen what looks like a stellar interest rate. Buyer beware. An advertised interest rate isn't necessarily the same as your loan's APR. The interest rate refers to the annual cost of a loan to a borrower and is expressed as a percentage. The APR is the annual cost of a loan to a borrower — including fees. Like the interest rate, the APR is expressed as a percentage. But, unlike an interest rate, it includes any additional charges or fees such as origination fee, closing costs, or home appraisal fees.

Hot tip: If a lender has no closing costs or fees, the rate and APR will likely be the same percentage.

3. Rate locks are a possibility

HELOCs traditionally have a variable APR however there's a fixed rate option called a “Rate Lock.” While a variable rate tends to offer borrowers a lower rate than that of a fixed rate, some borrowers prefer a fixed rate to have a clear picture of what their monthly payment will be. So, here are some details:

• Lenders with a Rate Lock feature allow customers to lock a certain amount (or all) of their line of credit's outstanding balance at a fixed rate at terms of five, 10, 15, or 20 years.
• Implementing a fixed rate on your outstanding HELOC balance could increase your existing variable APR by 5% or more depending on the agreed upon term.

4. HELOCs aren’t just for houses!

Not everyone owns a standalone house. But you don't need a standalone house to have a home – or a HELOC. A condo, row home, multi-family home or town home are eligible properties to take out a HELOC. If you meet the lender requirements, you may also be able to borrow against the equity you have established in a second home or vacation property.

Hot tip: Keep in mind if your property is in a flood zone a lender may require you to have adequate flood insurance to obtain a HELOC.

5. Closing costs and annual fees vary

Closing costs on a HELOC can range from non-existent, all the way to 5% of the loan amount. While some lenders do not charge closing costs, be sure to read the fine print. In terms of annual fees, some banks charge around $50 a year for a HELOC. Any closing costs or annual fees will often be folded into your loan that will carry through to your APR, just like on a first mortgage. Be sure to ask about these details up front so there are no surprises.

6. During the draw period payments are only required on the amount you borrow

There are two phases of a HELOC; the draw period and the repayment period. They are exactly as they sound; the draw period is the time where you can draw money from the line of credit (up to your approved limit of course). The draw period usually lasts about 10 years. During the draw period, payments toward the principal are optional. This means you're only required to pay the interest on the amount you take out. Once the repayment period begins, you can't draw any more money from the line of credit and will make principal and interest payments until you've paid back the entire loan. The repayment period could be up to 30 years, depending on the lender.

While you only pay interest on what you borrow during the draw period, you have the option to also pay down the principal as well. This differs from other types of loans, such as a home equity loan where you are required to pay interest and principal on the full amount starting day one.

To sum up a monthly HELOC payment:

1. Some lenders only require the borrower to pay interest on the amount they have drawn during the draw period, while others will require both principal and interest payments during the designated draw period.
2. Once the repayment period begins, your monthly payment will increase, possibly significantly, as you will be required to pay both principal and interest. The repayment period could be up to 30 years.

7. Some lenders have prepayment penalties

A prepayment penalty is charged if you pay off the outstanding balance and close the HELOC ahead of schedule. Penalties can amount to a few hundred dollars, but not all lenders have penalties so be sure to keep an eye out. Here's a scenario to watch out for:

Scenario:

Say you tap into your equity to fund improvements to a home you'll likely sell in a few years. Assuming you have a mortgage, the proceeds from the sale of your house will need to go toward paying off that mortgage as well as the HELOC. That said, you'll want to work with a lender who won't penalize you for paying off the HELOC ahead of schedule.

8. You can take out a new HELOC at the end of the draw period

At the end of the draw period, you may be able to open a new HELOC depending on your qualifications. This new line of credit could allow you to pay off your previous HELOC and borrow more for the future. You'll then re-enter the draw period and restart the clock.

Could a HELOC be right for you?

As with any loan, HELOCs have pros and cons, and only you know all the facts should you wish to take one out down the road. The interest rate of a HELOC is traditionally variable, so you should be prepared to budget for potential changes. Also, your home is the collateral, which might be more risk than some are willing to take on.

However, some pros are that HELOCs offer a way to tap into your home equity as you need it. Using your equity can act as a safety net for any unexpected costs, like health care bills or car troubles, or help finance home improvement projects that can improve your everyday living as well as possibly the value of your home. And with a lower interest rate than credit cards or personal loans, HELOCs can allow you to consolidate any high-interest debt into one monthly payment at a lower APR.

Get started on your bright future today, and know we're here to answer any questions you might have about this unique type of loan.