How Do You Shop For a HELOC?
October 20, 2003, Revised November 30, 2006, November 18, 2008
"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. In most respects, it is simpler, if you know what you are doing.
A HELOC is a line of credit, as opposed to a loan for a specified sum, and it is always adjustable rate. The bad news about that, which I discuss in What Is a HELOC, is that HELOCs provide borrowers with much less protection against interest rate increases than standard ARMs.
*The interest rate on the HELOCs adjust 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 ranging from a month to 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.
The good news is that HELOCs are easier to shop for. The major reason is that important features are the same from one lender to another. There may be some exceptions, but the interest rate on all the HELOCs I have seen is tied to the prime rate, as reported in the Wall Street Journal. In contrast, standard ARMs use a number of different indexes (LIBOR, COFI, CODI, and so on) which careful shoppers have to evaluate.
The critical feature of a HELOC that is not the same from one lender to another, and which should be the major focus of smart shoppers, is the margin. This is the amount that is added to the prime rate to determine the HELOC rate. Many if not most lenders do not volunteer the margin unless they are asked.
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%!
WARNING: Do not assume that the difference between your HELOC start rate and the prime rate is the margin. It may or may not be. Ask. Bear in mind, as well, that the margin varies with credit score, ratio of total mortgage debt to property value, documentation and other factors. You need the margin on your deal. If the lender is advertising a margin, it is on their best deal.
Truth in Lending (TIL) on a HELOC is a travesty. It requires that borrowers be given an APR which is the same as the interest rate. The borrower described above was given an APR of 4.5% early on, and when his rate jumped to 9.5% he was told that his new APR was 9.5%. TIL does not require disclosure of the margin.
If the HELOC will be used to meet future contingencies rather than to refinance an existing mortgage, the shopper needs to know whether there is a minimum draw at closing, or a minimum average loan balance. Lenders don’t make any money unless the HELOC is used, but they are not always forthcoming about this. 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. In addition, there are some uniquely HELOC charges that you should factor in. These include an annual fee, usually $25-$75 and often waived the first year; and a cancellation fee, perhaps $350-$500, which is usually waived if the account stays open for 3 years.
Here is your checklist: make sure the figures you get apply to your deal.
1. Introductory rate and period
2. Margin
3. Minimum draw
4. Required average balance
5. Upfront lender fees
6. Upfront third party fees
7. Annual fee
8. Cancellation fee
"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. In most respects, it is simpler, if you know what you are doing.
HELOCs Are Risky But Easy to Shop
A HELOC is a line of credit, as opposed to a loan for a specified sum, and it is always adjustable rate. The bad news about that, which I discuss in What Is a HELOC, is that HELOCs provide borrowers with much less protection against interest rate increases than standard ARMs.
*The interest rate on the HELOCs adjust 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 ranging from a month to 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.
The good news is that HELOCs are easier to shop for. The major reason is that important features are the same from one lender to another. There may be some exceptions, but the interest rate on all the HELOCs I have seen is tied to the prime rate, as reported in the Wall Street Journal. In contrast, standard ARMs use a number of different indexes (LIBOR, COFI, CODI, and so on) which careful shoppers have to evaluate.
Margin: the Critical Feature of a HELOCs
The critical feature of a HELOC that is not the same from one lender to another, and which should be the major focus of smart shoppers, is the margin. This is the amount that is added to the prime rate to determine the HELOC rate. Many if not most lenders do not volunteer the margin unless they are asked.
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%!
WARNING: Do not assume that the difference between your HELOC start rate and the prime rate is the margin. It may or may not be. Ask. Bear in mind, as well, that the margin varies with credit score, ratio of total mortgage debt to property value, documentation and other factors. You need the margin on your deal. If the lender is advertising a margin, it is on their best deal.
Ignore Truth in Lending on a HELOC
Truth in Lending (TIL) on a HELOC is a travesty. It requires that borrowers be given an APR which is the same as the interest rate. The borrower described above was given an APR of 4.5% early on, and when his rate jumped to 9.5% he was told that his new APR was 9.5%. TIL does not require disclosure of the margin.
Other Relevant HELOC Features
If the HELOC will be used to meet future contingencies rather than to refinance an existing mortgage, the shopper needs to know whether there is a minimum draw at closing, or a minimum average loan balance. Lenders don’t make any money unless the HELOC is used, but they are not always forthcoming about this. 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. In addition, there are some uniquely HELOC charges that you should factor in. These include an annual fee, usually $25-$75 and often waived the first year; and a cancellation fee, perhaps $350-$500, which is usually waived if the account stays open for 3 years.
Checklist for Shopping HELOCs
Here is your checklist: make sure the figures you get apply to your deal.
1. Introductory rate and period
2. Margin
3. Minimum draw
4. Required average balance
5. Upfront lender fees
6. Upfront third party fees
7. Annual fee
8. Cancellation fee