Ask Our Broker With Peter G. Miller: 'Fix' a HELOC
Question: We've been looking at getting cash out of our house by using a home equity line of credit (HELOC)? Does it make sense to get a convertible HELOC, one that we can switch to a fixed rate if we elect?
Answer: A HELOC can be a very alluring form of financing – but one with risks that should be understood.
Let's say you have a home worth $300,000 and a $140,000 mortgage balance. If the lender requires 20 percent equity to refinance, $60,000 in this case, then it might be possible to get a $100,000 HELOC ($300,000 less $60,000 = $240,000, and $240,000 less the $140,000 mortgage balance leaves $100,000).
The interest rate is adjustable and it’s 15-year financing. In the first five years, the draw period, the homeowner can borrow against the line. In years six through 15 the owner must repay the debt. The interest rate is adjustable, maybe 3.25 percent to start in the first year.
If the borrower takes out $75,000 at closing, the monthly interest-only payment will be $203 at 3.25 percent. But at the start of year, six things may be very different. If the interest rate has climbed to 5.5 percent and $75,000 still remains unpaid, the monthly payment will be $814. Why so much? Because only ten years remain to fully repay the debt.
If the rate goes to 8.25 percent – 3.25 percent plus 5 percent – the monthly payment will soar to $920. Some HELOCs have 7 percent lifetime caps.
Will the bigger payment be affordable? That depends on the borrower's income.
So is it a good idea to get a convertible HELOC, one that starts out as an ARM but can convert into fixed-rate financing?
It can be a very attractive proposition because you can't be turned down (no new loan application is required) and you don't have to pay the costs for a new closing (because the loan is being “modified” and a new loan is not being “originated”).
Converting to a fixed rate is not a sure winner either. If interest levels go up, the new fixed rate might mean higher monthly costs – and maybe very much higher costs.
Also, how will the fixed rate be determined? Will it be more than the prevailing rate at the time of conversion? Is there an additional fee to get a convertible HELOC or a special fee at the time of conversion? Or both?
Whether you have an adjustable or fixed-rate HELOC, you need to look ahead. What is the worst possible combination of loan balances and interest rates the loan can produce? If the worst happens will you be able to handle it?
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Peter G. Miller Peter G. Miller is author of "The Common-Sense Mortgage," (Kindle 2016). Have a question? Please write to peter@ctwfeatures.com.