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Overview
While it is essential to know the initial annual percentage rate (APR) of a home equity line of credit (HELOC) so that you can compare programs at different lending institutions, once it is obtained, the interest rate on a HELOC becomes variable. It has a variable rate because a HELOC is a line of credit, not a loan for a specific amount. A HELOC may have an introductory rate of interest that is comparatively low to encourage business.
Significance
Because a HELOC carries a variable rate, each time the prime rate increases so will the interest on your HELOC. The result will be an increase in your monthly payment. When interest rates are low, it may be more appropriate to have a home equity loan rather than a HELOC because, most often, its rate will be fixed.
How HELOC Rates Are Figured
Most lenders peg their variable interest rates on HELOCs at some margin over the prime rate. Each time there is movement in the prime rate, the interest rate on your HELOC will be adjusted. The difference among various lenders is the margin they add to the prime rate. It is more appropriate for a borrower to know the margin as opposed to the APR at the time the HELOC is secured, even though a borrower must be told of the APR as is required by federal law.
Effects
Let's say you arrange for a HELOC to pay the college tuition for your child. From the time that those funds are withdrawn, the variable interest rate increases from a modest 5.5 percent to 8.5 percent. If you have borrowed $50,000 and you have a 10-year HELOC, you monthly payments will rise by over $75.
Alternative
Assuming that you have a specific need for the funds that your HELOC will provide, and interest rates are at historic lows, you may consider refinancing your first mortgage with a fixed rate of interest instead of applying for a HELOC. First, you would avoid having a variable rate that could cause your monthly payments to rise. Second, your monthly payout will be less, because HELOCs usually have a 10-year maturity while a home mortgage is three times longer or more.
Benefits
Instead of interest rates on your HELOC rising, which will cause your monthly payments to rise as well, interest rates could fall. In that case, your monthly payments will also come down. While the ultimate cost of a HELOC will always be dictated by market conditions, there are historical periods where they make sense.
