"Do I shop for a HELOC in the same way as I would shop for another mortgage?"
No, shopping for a HELOC is very different from shopping for a standard mortgage. If you know the information you need, shopping is easier, but if you don't know what you need and don't ask the right questions, you are highly vulnerable to an overcharge. It is very unlikely that the lenders you contact will give you the information that you need unless you ask for it.
Step 1: Make Sure You Really Want a HELOC
A HELOC is a line of credit on which you can draw as you need funds, as opposed to a loan for a specified sum. This makes a HELOC the preferred way to finance outlays that occur intermittently, such as those arising from a sequence of home improvements. The borrower can draw on the line as payment needs arise.
The downside is that all HELOCs are adjustable rate mortgages (ARMs) and provide borrowers with much less protection against interest rate increases than standard ARMs.
- The interest rate on a HELOC adjusts the first day of the month following a change in the prime rate, which could be just a few days. (Exceptions are those HELOCs with an introductory guaranteed rate, but these hold only for 1 to 6 months). Standard ARMs, in contrast, fix the rate at the beginning for periods as long as 10 years.
- HELOCs have no limit on the size of a rate adjustment, and most of them have a maximum rate of 18 percent except in North Carolina, where it is 16 percent. Standard ARMs may have different rate adjustment caps and different maximum rates.
Step 2: Pin Down the Major Price Components
Borrowers who price shop for a HELOC will be quoted an interest rate. This is the start rate, which sometimes is shown as the APR. Don't be confused by that, on a HELOC the start rate and the APR are the same thing.
Typically the start rate holds for only a few months -- only rarely is it longer than 6 months. Usually you must ask how long the start rate holds. It is a question that most lenders prefer to avoid, because invariably it leads to another question: what happens to the rate at the end of the start rate period?
The answer is that the new rate will be set at the prime rate plus a margin. The prime rate is the same for everyone, currently it is 3.25 percent and has been since December 2008. But don't let that fool you, it can accelerate very quickly. In 1980, it hit 20 percent. Whenever the prime rate changes, the HELOC rate changes by the same amount.
The margin is the amount that is added to the prime rate to determine the borrower's rate when the start rate period ends. The margin is borrower specific - it can vary with a number of features of the borrower and the property, but the major ones are the borrower's credit score and the amount of equity supporting the HELOC. Equity is the property value less the balance on a first mortgage if there is one less the maximum draw amount on the HELOC.
Obviously the critical price feature of a HELOC, which should be the major focus of smart shoppers, is the margin. They won't get any help from the lenders because the dominant practice is to quote the start rate, which is like an automobile dealer advertising the price of the tires. Truth in Lending helps not at all because the margin is not a required disclosure.
WARNING: Do not assume that the difference between your HELOC start rate and the prime rate is the margin. Here is what can happen when you don't ask. Borrower X, who provided me with his history, was offered an introductory rate of 4.5 percent for three months. He was told that after the three months the rate "would be based on the prime rate." At the time the loan closed, the prime rate was 4 percent. Three months later, the prime rate was still 4 percent, but the rate on his loan was raised to 9.5 percent. It turned out that the margin, which the borrower never asked about, was 5.5 percent!
Step 3: Check Out Other Relevant HELOC Features
The borrower who plans to draw on the HELOC over time will want to know whether there is a minimum draw at closing, or a minimum average loan balance. Borrowers who are uncertain about future usage don't want to be forced to borrow money they won't need.
Upfront fees are the same types as on standard mortgages, except that HELOC lenders seldom charge points, and third party fees tend to be small and are often paid by the lender. Some other uniquely HELOC charges that you should factor in are a cancellation fee, perhaps $350-$500, which is usually waived if the account stays open for 3 years; and an annual fee, usually $25-$75 which is often waived the first year.
Checklist for Shopping HELOCs
Here is your checklist: make sure the figures you get apply to your deal.
- Introductory rate and period
- Upfront lender fees
- Upfront third party fees
- Minimum draw if any
- Required average balance if any
- Cancellation fee if any
- Annual fee if any