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A secured loan such as a home equity line of credit (HELOC) is among the most sought-after ways for homeowners to pay for expensive home improvements and to bear other real estate expenses. However, while qualifying for HELOC may be easy, just as long as credit scores are healthy and the homeowner has sufficient equity in the house, paying the loan back is often more difficult.
The reason for this is that a home equity line of credit comes with a variable rate of interest. This means that the rate of interest charged can change. Depending on market conditions and that directly affects how much the monthly payments are.
But just how often can interest rates change on a HELOC? We’re going to answer this question and more to help you understand how HELOCs work better.
An introduction to HELOCs
The word HELOC stands for home equity line of credit. Essentially, it is a credit limit that is extended to homeowners by financial institutions based on the amount of equity they have in their home.
Most financial institutions offer homeowners a certain percentage of the equity they have in their homes. In most cases, this is around 85%. The amount is decided based on a variety of factors. Factors such as the value of the property, and the equity the homeowner has in the property. Also, debt to income ratio, credit scores and more.
A lot of this is similar to home equity loans. However, there are major differences. For one, home equity loans offer borrowers a fixed amount of money, and are fixed interest rate loans.
Also, HELOCs offer borrowers a line of credit that they can draw in parts over a stipulated period of time. You can find this as a draw period. Draw periods are typically set between five to ten years.
During this period of time, the borrower only pays interest only on the amount of money used, similar to credit cards. Post the drawing period, the borrower pays both interest and the principal back to the lender. This period is called the HELOC reset.
Understanding variable interest rates
However, HELOCs charge variable interest rates, which means monthly payments are liable to change. Variable interest rates means that the interest rate is based on a benchmark index rate or prime rate. It’s usually linked to the federal funds rate. This is liable to change as the index experiences changes in the market.
This obviously means that while interest rates can drop, meaning the monthly payments required decrease, the opposite is also likely to happen. As the interest rate increases, so will the amount due on monthly payments.
How often can interest rates change on a HELOC?
Based on the existing prime rate environment, or the lowest interest rates chargeable to borrow money commercially, the interest rates on a HELOC can change as often as every month.
It is mandatory for financial lenders to explain the effects of decreasing and increasing interest rates on monthly payments. Whether after the raw period to all borrowers, as well as how often these rates can change. Therefore, even if these rates do change on a monthly basis, you can consider a change in the terms of repayment of the loan.
However, you can expect lenders to inform borrowers about the change in rates. This happens as a part of periodic statements you send after payment before the next one is due.
Why do people find it difficult to pay back HELOCs?
Other than the fact that HELOCs have a variable rate of interest, one of the biggest reasons why borrowers find it difficult to repay HELOCs is because they forget about what their repayment term is, or simply put, how long they have to pay back the loan.
Let’s consider an imaginary situation to help us better understand why the repayment period is so important. Let us suppose a homeowner borrows a certain amount as a HELOC, with a repayment term of 15 years.
Now, if the draw period on that loan is 10 years, that means the borrower only pays interest on the amount borrowed for those ten years. However, once the draw period is over and the HELOC resets, the homeowner only has five more years to repay the full principal amount as well as interest on that amount. And that amount could keep changing because the variable interest rates clause includes the risk of rising interest rates.
Options if a borrower cannot repay HELOCs
Considering HELOCs use the home as collateral, it is really not advisable to default on payments. However, for those borrowers who find it difficult to repay HELOCs, there are certain options they could reconsider.
- Refinance the HELOC with a second mortgage. Thanks to fixed mortgage rates, the borrower knows exactly how much you own each month.
- Combine the existing mortgage and the HELOC into a single new loan. While this may reduce the monthly payments due, it is bound to increase the overall interest you pay and increase the repayment term.