How Do You Shop For a HELOC?
October 20, 2003, Revised November 30, 2006, November 18, 2008, October 7, 2015
"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.
The HELOCs have no limit on the size
of a rate adjustment, and most of them have a maximum rate of
18% except in North Carolina, where it is 16%. Standard ARMs may
have different rate adjustment caps and different maximum rates.
Step 2: Pin Down the Major
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% and has been since December 2008. But
don’t let that fool you, it can accelerate very quickly. In
1980, it hit 20%. 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% for 3 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%. Three months later, the
prime rate was still 4%, but the rate on his loan was raised
to 9.5%. It turned out that the margin, which the borrower
never asked about, was 5.5%!
Step 3: Check Out Other Relevant
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.
2. Introductory rate and period
3, Upfront lender fees
4. Upfront third party fees
5. Minimum draw if any
6. Required average balance if any
7. Cancellation fee if any
8. Annual fee