How to get the best HELOC rates

Make sure you understand how HELOC rates work to save the most money. (iStock)

Recent changes in interest rates make taking out a home equity line of credit (HELOC) very appealing. A HELOC works as a line of credit, similar to a credit card. When approved, your lender will extend a line of credit that you can access for a set period. You can use as much or as little of the credit line during the withdrawal period. In contrast, a home equity loan pays out in a lump sum.

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Like most personal loans, you can use a HELOC for anything from home renovations to vacation or covering an emergency expense.

How does a HELOC interest rate work?

Unlike most credit cards and most personal loans, the typical HELOC has a variable interest rate. A variable-rate means that your interest rate can (and will) change over the life of your investment. Your lender will determine how often the rates vary; this can range from monthly to annually.

When determining your monthly payment, your lender will use margin (the interest rate) and an index to decide on your total interest rate. Lenders use unique formulas combining the two elements to determine how much you owe. Most lenders only advertise the APR based on the interest rate and not additional factors, so make sure to read the fine print in your contract.

When you have a variable interest rate, your interest rate could go up or down depending on the market. Additionally, a variable rate means that your monthly payment could go up or down as well. Some lenders will allow you to choose a fixed rate, but they may charge a fee for the option.

You are charged interest only on the portion of credit you use. For example, if your lender gives you a HELOC for $50,000 and you only ever use $30,000, you only pay interest on the $30,000, not the total available.

Typically, interest rates on a HELOC will be lower than on a home equity loan.

How to get the best HELOC rates

The most important thing you can do to secure the best interest rates on your HELCO is to shop around. Talk to multiple lenders. One common mistake a borrower makes is just taking the numbers their current mortgage holder offers. Failing to check out another option could cost you a lot of money.

When shopping around, look at introductory rates. Many lenders offer a low initial rate to entice customers. The initial offers typically last up to a year. While these rates can be very tempting, just remember that your payment could significantly increase once the introductory period ends.

To save the most money on a variable interest rate, make sure you work with a lender that offers a low HELCO rate cap. The rate cap is the maximum amount of interest the lender can charge. Knowing this number can help planning your repayment a little easier.

Don’t be afraid to ask multiple lenders for offers. You can even tell the lender you’re shopping around and see if they’re willing to meet or beat a competitor’s offers.

Like other lines of credit, you can improve your chances of getting a lower interest rate by improving your credit score, paying your bills on time, and keeping your debt-to-income ratio low.

What to avoid when looking for a HELOC lender

One of the sneakiest ways you can lose money on a HELOC is through inactivity fees. Some lenders charge you for not taking a withdrawal. They’re essentially charging you for not borrowing money. Make every effort to avoid this fee.

Another fee to watch out for is the prepayment penalty. Many lenders add in a fee if you pay off your HELOC early (like if you choose to sell your home). You can avoid this fee by working with lenders who don’t charge prepayment penalties if you think you may need to sell your home during the withdrawal period.

You won’t be able to avoid all fees associated with a HELOC, but you should know what you’re paying so you can save as much money as possible. Standard fees you’ll see when getting a home equity line of credit include:

  • Loan origination fees.
  • Minimum withdrawal fees.
  • Minimum balance fees.
  • Transaction fees (charged each time you take out money).
  • Annual fees.

One final note: Remember that when you take out a HELOC, you are using the equity on your property to secure the debt. If you are unable to repay your HELOC, you could lose your home. Most lenders cap the amount they lend at 80 percent of the equity in the home. Make sure only to use what you can afford to pay back to avoid putting your house at risk.