"I have been advised to refinance with a HELOC rather than with a standard mortgage. Could you explain the difference, and why one might be better than the other?"
Characteristics of HELOCs
HELOC stands for home equity line of credit, or simply "home equity line." It is a loan set up as a line of credit for some maximum draw, rather than for a fixed dollar amount.
For example, using a standard mortgage you might borrow $150,000, which would be paid out in its entirety at closing. Using a HELOC instead, you receive the lender’s promise to advance you up to $150,000, in an amount and at a time of your choosing. You can draw on the line by writing a check, using a special credit card, or in other ways.
Most HELOCs are second mortgages. An increasing number, however, are first mortgages, as yours would be if you used it to refinance your existing first mortgage. Using a HELOC as a substitute for a first mortgage can save a lot of money in the short-run, but is very risky. See Take a Flyer With a HELOC?
HELOCs have a draw period, during which the borrower can use the line, and a repayment period during which it must be repaid. Draw periods are usually 5 to 10 years, during which the borrower is only required to pay interest. Repayment periods are usually 10 to 20 years, during which the borrower must make payments to principal equal to the balance at the end of the draw period divided by the number of months in the repayment period. Some HELOCs, however, require that the entire balance be repaid at the end of the draw period, so the borrower must refinance at that point.
Interest on a HELOC
Because the balance of a HELOC may change from day to day, depending on draws and repayments, interest on a HELOC is calculated daily rather than monthly. On a 6% HELOC, interest for a day is .06 divided by 365 or .000164, which is multiplied by the average daily balance during the month. If this is $100,000, the daily interest is $16.44, and over a 30-day month interest amounts to $493.15; over a 31 day month, it is $509.59.
In contrast, on a standard 6% mortgage, interest for the month is .06 divided by 12 or .005, multiplied by the loan balance at the end of the preceding month. If the balance is $100,000, the interest payment is $500, regardless of whether there are 30 or 31 days in the month -- or 28.
APR on a HELOC
Don’t compare the APR on a HELOC with the APR on a standard loan because they mean different things. The APR on a HELOC is the interest rate, period. Among other things, it does not reflect points or other upfront costs, as the APR on standard loans does. Requiring lenders to show the interest rate on a HELOC twice is a strange way to protect borrowers, but there it is. See How Do You Shop For a HELOC?
Advantages of HELOCs
HELOCs are convenient for funding intermittent needs, such as paying off credit cards, making home improvements, or paying college tuition. You draw and pay interest on only what you need.
Upfront costs are also relatively low. On a $150,000 standard loan, settlement costs may range from $ 2-5,000, unless the borrower pays an interest rate high enough for the lender to pay some or all of it. On a $150,000 HELOC, costs seldom exceed $1,000 and in many cases are paid by the lender without a rate adjustment.
Some HELOCs are convertible into fixed-rate loans at the time of a drawing. This is a useful option for borrowers who draw a large amount at one time.
The Risks of a HELOC
he major disadvantage of the HELOC is its exposure to interest rate risk. All HELOCs are adjustable rate mortgages (ARMs), but they are much riskier than standard ARMs. Changes in the market impact a HELOC very quickly. If the prime rate changes on April 30, the HELOC rate will change effective May 1. An exception is HELOCs that have a guaranteed introductory rate, but these hold for only a few months. Standard ARMs, in contrast, are available with initial fixed-rate periods as long as 10 years.
HELOC rates are tied to the prime rate, which some argue is more stable than the indexes used by standard ARMs. This is an illusion, however, arising from the fact that the prime rate doesn't change from day to day. In 2003, it changed only once, to a low of 4% on June 27. However, in the next three years it changed 17 times, by .25% each time, reaching 8.25% on June 29, 2006. In 1980, it changed 38 times and ranged between 11.25% and 20%.
In addition, most standard ARMs have rate adjustment caps, which limit the size of any rate change. And they have maximum rates 5-6% above the initial rates. HELOCs have no adjustment caps, and the maximum rate is 18% except in North Carolina, where it is 16%.
HELOCs In the Financial Crisis
The financial crisis that erupted in late 2007 revealed another risk in HELOCs, which is that the lender has the right to cut an unused credit line. With property values declining during the crisis, many lenders did this, with the result that the borrowers found that they did not have the loan commitment they thought they had.
On the other hand, the crisis also saw a marked decline in the prime rate to which HELOC rates are tied. In the first 6 months of 2009, borrowers with a margin of zero were paying the prime rate of 3.25% on their HELOC balances. Those with negative margins, negotiated during pre-crisis years when prime was higher, were paying even less. The temptation to convert other mortgages to HELOCs, however, was tempered by the knowledge that the advantage could be transformed into a disadvantage very quickly if market rates suddenly rose. See Take a Flyer With a HELOC?