How is interest calculated on a HELOC?

A home equity line of credit is a popular financial tool that allows homeowners to borrow against the equity they've built in their homes. It works like a credit card, offering significant flexibility at more competitive rates than traditional debt products. 

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However, understanding how repayment works is crucial to using this valuable resource effectively. In this post, we'll explore how interest on a home equity line of credit (HELOC) works and answer frequently asked questions about HELOC repayment. 

How does HELOC repayment work?

A HELOC has two phases—the draw phase and the repayment period—each of which has its own payback structure. 

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The draw phase is a 5 to 10-year term in which you can draw funds as needed, up to the set credit limit. During this phase, you’re responsible for interest-only payments. However, you can make principal payments to pay off your HELOC faster. 

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Once the draw phase ends, the repayment period begins, which is generally 10 to 20 years. During this period, you can no longer draw funds and the outstanding balance is converted into a principal-plus-interest loan. You’ll be on the hook to repay both the principal and interest with a single monthly payment. HELOCs come with variable interest rates, which could potentially fluctuate monthly payments.

How are HELOC rates determined?

HELOC rates are determined by market conditions and a borrower's creditworthiness. 

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Lenders will use a Prime Rate, which is influenced by the Federal Reserve's decisions on interest rates, to set a benchmark index. When the Fed raises or lowers rates, the Prime Rate tends to follow, which could increase or decrease your rate. 

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Lenders also use creditworthiness when determining an individual's rate. During the underwriting process, a borrower's credit score, debts, and combined loan-to-value ratio (CLTV) are evaluated. Borrowers with higher credit scores and lower debt are typically offered lower interest rates. 

How is HELOC interest calculated?

During the draw period, HELOC interest is calculated daily. The lender multiplies your daily balance by a daily interest rate, which is the HELOC interest rate divided by the number of days in that year. At the end of the billing cycle, all the daily interest charges are added together to calculate your monthly interest payment. 

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For example, if your HELOC has a balance of $50,000 and an annual interest rate of 6%, your daily interest rate would be 0.06 ÷ 365 = 0.000164. Multiply that by your $50,000 balance, and you get a daily interest charge of $8.22. Over a 30-day period, your interest charges would total around $246.60.

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During the repayment period, interest works like a traditional mortgage loan. 

Tips for HELOC repayment

Here’s how to stay on track and reduce the financial burden of HELOC repayment:

• Make principal payments during the draw period: Since HELOC interest is calculated daily, making more frequent payments can reduce the amount of interest you owe. It can also reduce the outstanding balance you’ll have come the repayment period. 
• Make extra payments during the repayment period: Small, extra weekly or bi-weekly payments can help chip away at your balance and lower the total interest paid over time. Just be sure to ask your lender whether there are any prepayment penalties. 
• Switch to a fixed-interest rate HELOC: Ask your lender if you can lock into a fixed-rate HELOC. By doing so, you can protect yourself from rising rates. 
• Refinance if needed: If interest rates rise, refinancing your HELOC to a fixed-rate home equity loan or even a cash-out refinance might be a wise option. This can give you more predictable monthly payments and protect you from further rate increases.

HELOC alternatives

A HELOC can provide a significant amount of flexibility. However, if HELOC repayment doesn't suit your needs, consider exploring:   

• Home equity loans: Unlike HELOCs, home equity loans provide single lump sum payouts with a fixed interest rate and fixed monthly payments. Repayment can range from 5 to 30 years. Requirements are similar to HELOCs, although home equity loans may be easier to obtain with less-than-great credit.  
• Home equity investments (HEI): HEIs also provide a lump sum upfront, however, unlike HELOCs or home equity loans, there are no monthly payments. Instead, you share a portion of your home's future appreciation when you decide to pay back your HEI—which can be anytime during a flexible 30-year term. Requirements are less stringent; you'll need a credit score above 500 and sufficient equity to qualify. There are no income requirements.  
• Refinancing: If interest rates are lower than when you took out your mortgage, you could refinance your current mortgage. A cash-out refinance replaces your existing mortgage with a new larger loan, providing you with the difference in cash. 
• Reverse mortgages: For homeowners aged 62 years or older, a reverse mortgage can help you tap into your equity for a single lump sum payout, monthly payments, or a line of credit. There are no monthly payments; the loan is settled when the homeowner moves or passes away. Requirements vary from lender to lender. These types of loans are tricky, so it’s best to consult a financial advisor.
• Personal loans: If closing costs or the risk of foreclosure—which are considerations for all home equity products—feel too great, a personal loan may be worth exploring. The origination fees on personal loans are much lower than other products. Plus, you can find fixed monthly payments with a loan. Unfortunately, like credit cards, personal loans have higher interest rates. 

Frequently asked questions

What do you need to qualify for a HELOC?

To qualify for a HELOC, lenders typically require a credit score of 620 or higher, at least 15-20% equity in your home, a debt-to-income ratio below 43%, and proof of sufficient income. Some lenders are more flexible and may be willing to accept a lower credit score or higher DTI, so it's important to shop around. 

What can you use a HELOC for?

There are no restrictions on how you can use your HELOC funds. Most homeowners leverage a HELOC for home improvements, debt repayment, and other financial goals (like paying for education-related expenses or small business needs). 

Is HELOC interest calculated daily or monthly?

During the draw phase, HELOC interest is calculated daily. Alternatively, interest is usually calculated monthly during the repayment period. 

Do HELOCs compound interest?

Many HELOC lenders use simple interest rather than compounding interest to calculate payments. However, some lenders do leverage compound interest (where interest builds on top of interest), so it’s essential to read the terms and conditions offered to you. 

How often can the interest rate change on a HELOC?

HELOC interest rates typically change in response to fluctuations in the Prime Rate. The Federal Reserve can adjust rates up to eight times throughout a given year. When rates rise, you may see an increase in your monthly payments. 

Is there a downside to having a HELOC?

There are a few considerations to explore before moving forward with a HELOC. One of the most significant risks is the potential to lose your home should you default on the loan. Additionally, if the market experiences a downturn and you owe more than your home is worth, you'll likely have difficulties selling or refinancing the property. Other considerations are the closing costs and fees associated with HELOCs and the ability to borrow more than you can realistically afford. 

Final thoughts

A HELOC is a resourceful way to tap into your home equity to accomplish your goals. However, it's crucial to remember that it's a debt that must eventually be paid back. When considering a HELOC, take the time to assess the interest rate structure and your ability to handle variable payments. 

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If a HELOC doesn't suit your financial needs, consider alternatives to find a better fit. Be sure to explore all your options and choose the one that aligns with your financial goals.