If your home equity line of credit is approaching its 10th birthday and you owe money on it, you might soon see a spike in the minimum monthly payments. You can delay the payment increase by refinancing the loan.
A home equity line of credit, or HELOC, has 2 stages. First is the draw period, which usually lasts 10 years but can be as long as 20 years. Monthly payments are applied only to the interest during the draw period.
After the draw period ends, the second stage begins: The HELOC goes into the amortization period when you have to pay principal as well as interest. Monthly payments go up. If you still owe a lot, the payments rise abruptly. That's why some homeowners look for ways to refinance their HELOCs.
HELOC payments rise abruptly
"Many people were unaware of how drastically their payment is going to go up," says Peter Grabel, managing director with Luxury Mortgage in Stamford, Connecticut. "They've been making a nice, low payment of interest only for 10 years at a very low rate."
Monthly payments on a HELOC, during and after the draw period
The monthly payments rise sharply when the amortization period begins on a home equity line of credit. These payment amounts assume a 3% interest rate and a 20-year repayment period. Payments would be more with a higher interest rate or a shorter repayment period.
In pointing out a version of the above scenarios, Grabel notes that they don't take into account the likelihood of higher interest rates in coming years.
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Lenders remind borrowers
Banks encourage customers to deal proactively with this issue. According to Cynthia Balser, senior vice president and group manager of consumer credit products at KeyBank, "Somewhere between 6 to 12 months before the end of the draw period, banks are beginning to reach out, reminding clients that a decision they made 10 or 15 years ago is about to come due and asking the client to reach out if they have any concerns or questions."
3 options to refinance a HELOC
If you want to cushion the amortization period of a HELOC, there are 3 options:
- Refinance the HELOC. When you refinance a home equity line of credit, you start over with a new HELOC, with its own interest-only draw period.
With this approach, you still have access to a credit line to deal with future needs. You will still have to pay off the balance someday. Rick Huard, senior vice president of consumer lending product management at TD Bank, notes: "99% of HELOCs are variable rate and nobody knows what rates will do a year from now."
- Pay off the HELOC with a home equity loan. A home equity loan is for a fixed amount with a fixed rate. The payments remain the same through the life of the loan.
- Refinance the HELOC and the first mortgage into a new primary mortgage. By refinancing the HELOC into a new primary mortgage, you could take advantage of a fixed interest rate that's still low by historical standards. Consider refinancing into a 15- or 20-year mortgage to reduce total interest payments.
While interest rates on primary mortgages are favorable, you have to take into account higher closing costs when you take this approach. It's best if you keep the house long enough for the cumulative monthly savings to outweigh the costs of refinancing.
Weigh all the costs
Home equity loans have much lower closing costs than primary mortgages. The disadvantage is that interest rates on equity loans are typically higher than on primary mortgages.
If you refinance into another HELOC, be aware of the heightened underwriting standards. Ten years ago, you could qualify on the basis of the interest-only payments. Today, you have to prove that you can afford the fully amortizing payments.
And if this is your first mortgage application since 2008, you might be surprised by how much documentation you will have to provide.
Underwater homes are an exception
Even though home values have been recovering, what if you still owe more than your home is worth?
"If the value is not there now, it's going to be difficult to qualify for a new loan," Huard says. "That's one of the situations where you definitely need to contact your bank, talk to your loan officer and see what options you have available. They can take a look at your financial picture and be able to work things out with you."
For instance, the bank could come out with a plan that would help you repay the loan by extending the term of the loan.