What is a HELOC

What is a HELOC & should I use one?

Posted on December 10, 2015 by Karen Barber in Market Updates

In real estate investment you will always hear how people were able to start out investing. A common way many people get their start is using a HELOC or a Home Equity Line of Credit. A HELOC basically is a Line of Credit (LOC) that has a maximum dollar amount set that you can draw against at any time up to the maximum dollar amount that has been agreed upon.

Using a standard mortgage you would borrow $100,000.00, which would be paid out in its entirety at closing the house you are purchasing. Using a HELOC instead, you receive the lender’s promise to advance you up to $100,000.00, in an amount and at a time of your choosing, when you need it. You can draw on the line by writing a check, using a special credit card, or how your financial institution has set it up.

Most HELOCs are second mortgages. However, some 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 can save a lot of money in the short-run, but is very risky.

HELOCs have a draw period which the borrower can use the line. A repayment period during which it must be repaid. Draw periods usually are 5 to 10 years, during which the you are only required to pay interest. Repayment periods are usually 10 to 20 years, during which you 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 will require that the entire balance be repaid at the end of the draw period, so you will need to refinance at that point.

Interest on a HELOC

Because the balance of a HELOC will change from day to day, depending on how it is setup, interest on a HELOC is calculated daily rather than monthly. Example 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 $100,000.00, the daily interest is $16.44, and over a 30-day month interest amounts to $493.15 or over a 31 day month it will be $509.59.

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, regardless of whether there are 30 or 31 days in the month — or 28.

APR on a HELOC

Don’t make a mistake & compare APR on a HELOC with the APR on a standard loan because they are totally different things. The APR on a HELOC is the interest rate, period. 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.

Advantages of HELOCs

HELOCs are convenient for funding intermittent needs, such as paying off credit cards, making home improvements, or paying college tuition, medical emergencies, it’s up to you. You draw and pay interest on only what you need at that specific time.

Upfront costs are also relatively low. On a $100,000.00 standard loan, closing costs may range from $ 2-5,000.00, unless the borrower pays an interest rate high enough for the lender to pay some or all of it. On a $100,000.00.00 HELOC, costs seldom exceed $1,000.00 and in many cases are paid by the lender without a rate adjustment.

Some HELOCs can be converted 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.

The Risks of a HELOC

As with everything in life, some things do seem to be too good to be true. The major disadvantage of the HELOC is its exposure to interest rate risk. All HELOCs are adjustable rate mortgages (ARMs), the 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.

HELOC rates are tied to the prime rate, which some argue is more stable than the indexes used by standard ARMs. This is an illusion, however, arising from the fact that the prime rate doesn’t change from day to dayIn addition, most standard ARMs have rate adjustment caps, which limit the size of any rate change. HELOCs have no adjustment caps.

The decision is up to you, as an investor, do you feel confident in using a HELOC to purchase a rental property?

One reason would be to use a HELOC to purchase a cash-flowing property. As always you will need to research the property, is it cash-flowing, will it be able to cover the interest payment, the property management fee (if you use a PM firm), the maintenance, taxes etc? If so, instead of making just an interest payment, many find that they can use a HELOC take the total rent payment received & pay the line down much faster (above the interest payment). This will allow you to pay the line down & possibly in 3 – 5 years as they are only required to make interest only reduce the HELOC & in turn borrow again & get another property.

As always, research all avenues to see what will be the best for your situation and always contact your CPA or Financial Planner to see what will be the best for your future.