3 Reasons You Might Want to Convert Your HELOC Balance to a Fixed Rate Loan Option
Reading time: 6 Minutes
By Ilana Polyak
October 10th, 2019
When you're “home rich,” but strapped for cash, a home equity line of credit (HELOC) can be a convenient and low-cost way to access money for home improvement projects, debt consolidation, big-ticket undertakings and the like. After all, who can come up with $20,000 for a leaky roof that needs to be replaced in the same week that the car is totaled and the refrigerator goes on the fritz?
However, there may come a time when you don't want to incur any additional debt, or perhaps you've reached the amortization period of your loan, and are facing the prospect of a sizable balloon payment in your near future.
If your HELOC isn't making sense for you any more, you may want to consider converting all or part of its balance into a fixed-rate loan option.
To get the most out of your HELOC, it's important to understand how it works and what you can expect from it. Let's run through the basics:
The HELOC ABCs
A HELOC is a line of credit, backed by your home as collateral. To qualify for one, you'll need to meet the lender's minimum requirements for credit score, debt-to-income ratio, home value and other factors.
If you meet those qualifications, you can generally borrow up to 85 percent of your home's value, minus the amount you still owe on the mortgage loan. For example, if your property is appraised at $400,000 and you owe $150,000, you would calculate 85 percent of the total value, which comes to $340,000. Then subtract $150,000, giving you a maximum line of credit of $190,000.
HELOCs function much like a credit card: You can withdraw as many times as you like, within your credit limit. (Some lenders also have a minimum draw amount. And remember, unlike a credit card, a HELOC is secured by your house.) As any outstanding balances are paid, the amount of credit available is also replenished. However, this feature exists for a limited amount of time, called the draw period, which varies in length depending on the term set by the lender. During the draw period, you may only be required to make interest payments, but can make additional payments toward the principal if you wish. After the draw period, you either enter into the repayment period, during which you can no longer draw and your required payments increase to include interest and principal, or you reach the deadline for the balloon payment, at which time the remaining balance of the loan is due.
What makes HELOCs attractive to most homeowners is that typically they come with a low introductory promotional interest rate, which generally lasts for one to four years. After the promotional rate ends, the interest rate typically increases to a variable rate, which fluctuates with the market. Over the years, the interest rate on your loan may change many times—and not always in the direction you want. For example, between December 2016 and December 2018, the Prime Rate (an index often used for variable rate HELOCs) rose from 3.75 percent to 5.50 percent.
Some HELOCs come with a fixed-rate loan option, allowing you to convert all or part of the balance of your line of credit into a fixed-rate loan. If you convert any part of your balance into a fixed-rate loan option, subsequent draws on the remainder of your HELOC would still be subject to adjustable interest rates. There may be a limit on the number of fixed-rate loan options you can have at one time—usually three to five—and you'll want to inquire about whether conversion involves any fees. Also keep in mind that lenders may also have minimum and/or maximum amounts that can be converted.
So should you convert your HELOC's balance to a fixed-rate loan option? Consider it if one of these reasons makes sense to you.
1. You want to take advantage of low rates.
Even if mortgage rates are falling, who knows how long that will last. The Federal Reserve can raise interest rates (which typically drives all rates higher) and their timing is not always predictable. Rather than trying to time interest-rate swings, consider taking advantage of low rates when they are available.
Bear in mind that there may be a fee for converting your balance to a fixed-rate loan option, and your monthly payments may increase because they would also include principal.
2. You need more stability in your finances.
Even if you expect interest rates to fall in the near future, anything with an adjustable rate adds a layer of uncertainty to your finances. Some people have budgets that let them take on that uncertainty without worrying too much. Others need to know exactly how much they'll be paying each month for their HELOC and how it fits into their budget. A fixed-rate loan option means there won't be any surprises from your HELOC at a time when you're dealing with ups and downs elsewhere in your finances.
Also, you may want to speed up the rate at which you're repaying the money you've borrowed, if, for example, you've purchased items such as an automobile that will depreciate faster than it will take to pay off your HELOC.
3. You want to manage your monthly payments during the repayment period
During the draw period of your HELOC, you typically only pay interest on what you've borrowed. Then your loan enters a repayment period during which you must repay both interest and principal. This period can be 10 years or as long as 20 years and most likely will have higher monthly payments if you weren't paying back any principal during the draw period. It's also possible your HELOC is structured with a balloon payment at the end of the draw period, requiring you to pay a hefty lump sum to close it out.
If you're able to refinance your debt by converting your HELOC balance to a fixed-rate loan option with a longer term, up to the end of the repayment period, it'll give you more manageable monthly payments during the repayment period.
A HELOC is a convenient way to unlock the equity in your house, with the flexibility to draw cash as you need it. But the uncertainty of fluctuating interest rates may leave you worried about how the loan will fit into your budget. A fixed-rate loan option gives you the benefit of certainty, which can be a real plus.
Ilana Polyak writes about the ways we can all make better financial decisions. She covers topics ranging from investing, retirement, college funding, taxes, credit cards and insurance.
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