A home equity line of credit typically carries an adjustable rate of interest. This carries some real risk for you if you take one out, since you can't predict what your payments will be in the future. If interest rates go down, your payments will go down, but if rates go up, your payments will increase. One tool that HELOCs are legally required to offer is a lifetime rate cap that limits how much their rate can change over time.
Most HELOCs have two components to their interest rates: the index and the margin. The index rate is a market-variable interest rate, selected by the lender from several published interest rates, that serves as the basis for your HELOC once it starts adjusting. Usually, the index rate is the prime rate. The margin is an additional amount that your lender adds on to that base index rate. For instance, if your loan has a 2-percent margin, also described as 200 basis points, your interest rate would be whatever the prime rate is, plus 2 percent. If the prime rate is 3.25 percent, you'd pay 5.25 percent, but if it goes up to 14 percent, you could end up paying 16 percent. The interest rate on a HELOC is frequently described as an annual percentage rate, or APR.
Fixed vs. Adjustable
Some HELOCs don't start out at the calculated index-plus-margin interest rate. Instead, they may have an initial fixed rate. For instance, if you have a fixed rate of 3.99 percent, you'd only pay that interest rate while the fixed rate was in place. Once it expires, your rate will begin to adjust up or down with the index rate.
Adjustments and Caps
Typically, once an adjustable HELOC enters its adjustment period, it adjusts freely on a monthly basis. When the index rate has a large jump, this can lead to large jumps in the payment. To mitigate this risk, HELOCs are structured with lifetime caps. For instance, if your HELOC has a lifetime cap of 18 percent and the prime rate goes to 17 percent, you won't pay more than 18 percent, even though your calculated rate with a 2-percent margin would be 19 percent. Some HELOCs may also have periodic caps that limit how much the rate can go up in a given adjustment period, although these aren't required by law.
Planning With Lifetime Caps
The lifetime cap is a useful planning tool. Although it doesn't tell you what your payment will be, it tells you what the worst possible payment would be. Before taking out a HELOC, you can have your banker use that lifetime cap rate to tell you what your payment could be in a worst-case situation. For instance, if you plan to borrow $45,000 on a HELOC with a 20-year payback period, and you expect the rate to be 6.25 percent, your payment would be $328.92. If the HELOC hit a lifetime cap of 16 percent, though, your payment could go up to $626.07.
Converting Your HELOC
One way to stop your HELOC from adjusting is to convert it to a fixed-rate loan. Sometimes, your lender will give you this option as a part of your HELOC's agreement. In other cases, you may need to refinance your HELOC into a new home equity loan or blend it with your first mortgage into a single large refinance. In either case, once you refinance your HELOC into a fixed-rate loan, you won't have to worry about rate adjustments anymore.
- The Mortgage Professor: What Is a HELOC?
- The Federal Reserve Board: What You Should Know About Home Equity Lines of Credit
- The Mortgage Professor: How Do You Shop For a HELOC?
- Federal Trade Commission. “Home Equity Loans and Credit Lines.” Accessed June 10, 2020.
- Federal Trade Commission. “Shopping for a Mortgage.” Accessed June 10, 2020.
- HousingWire. “Wells Fargo joins Chase in halting HELOCs.” Accessed June 10, 2020.
- Bank of America. “Make the Equity in Your Home Work for You.” Accessed June 10, 2020.
- Internal Revenue Service. “Publication 936 (2019), Home Mortgage Interest Deduction.” Accessed June 10, 2020.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.