With HELOCs, it pays to shop around
HELOC cost basics
- As a line of credit, you are typically only charged interest on the drawn amount.
- HELOC interest rates are adjustable and sensitive to short-term rate fluctuation.
- Lenders may charge penalties for inactivity or failing to maintain a minimum balance.
HELOCs are more like credit cards. The lender, typically a bank, extends a line of credit that the borrower can draw upon. The borrower is charged interest only on the amount drawn. Unlike most standard loans, the balances are revolving, meaning you can draw down and pay off the balance multiple times.
How do HELOCs work?
HELOCs usually have an initial draw period where you can take out cash against the line, and then a period where the outstanding balance must be paid off. During the initial draw period, you typically only make payments to cover the interest charges. After the draw period ends, you will be charged for interest, and you will pay down the outstanding balance. Once the draw period ends, you may notice a big increase in the amount of monthly payments.
Unlike many other types of loans, the interest rate on a HELOC is almost always adjustable. A lender typically charges a fixed percentage rate above the prime rate, which is known as the lender’s margin. Because overall interest rate is tied to the prime rate, HELOCs are particularly sensitive to the movement of short-term interest rates. If short-term rates rise, you pay more each month.
By law, however, lenders have to establish a lifetime cap, which establishes how high the interest rate can go. In many cases, HELOCs also carry period caps that place a limit on how high the interest rate can rise within a specific period, most typically a year. When evaluating a HELOC, it is important to look at the caps. Not all HELOCs have the same terms. These caps give you an idea of the maximum interest charges. By looking at the caps and other fees, you can shop for the best deal.
What are potential HELOC fees and penalties?
HELOCs often carry a number of other charges. For example, lenders sometimes tack on a so-called “lender fee” to cover the appraisal, document preparation and title verification.
In many cases, lenders slip in an annual fee. HELOC terms can extend for many years. Sometimes lenders add an annual fee, which could be in the range of $50 to $75.
You may be charged an “inactivity fee” if you don’t draw on your line of credit, or be penalized if you don’t maintain a minimum balance on the line. Sometimes lenders impose a stiff cancellation fee to close the line of credit or an early-prepayment fee if you decide to pay off your outstanding balance early.
As with the interest, the fees and penalties can vary. It is a good idea to shop around, read the fine print in the contract carefully and understand all of these fees. In many cases, the fees are negotiable, and the lenders will waive charges or reduce them.
One last fact about HELOCs is important to know. By federal law, if you sign a contract to open HELOC, you have three business days to cancel it without penalty.