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Many homeowners access their home's equity to fund a home renovation project, consolidate high-interest credit cards or cover a hefty medical bill. No matter the purpose, a second mortgage can give you access to a large loan with low interest rates, but you must use your home as collateral.
Taking out a second mortgage usually involves choosing between a fixed-rate home equity loan or a variable-rate home equity line of credit (HELOC). A fixed-rate HELOC combines the best features of these two loan products. A fixed-rate HELOC allows you to lock in an interest rate on an open-ended line of credit.
Before you take out a second mortgage, ensure you understand what a fixed-rate HELOC is, how it works and its benefits and downsides.
What Is a Fixed-Rate HELOC?
Like a traditional HELOC, a fixed-rate HELOC is a revolving line of credit that allows you to access the equity in your home and use the funds for any purpose. But while most HELOCs come with an annual percentage rate (APR) that fluctuates with market conditions, a fixed-rate HELOC locks in the interest rate on some or all of your available credit.
Make no mistake, variable-rate HELOCs are the norm in the marketplace. However, more lenders are beginning to offer fixed-rate HELOCs, and some offer the ability to convert a portion or all of a variable-rate HELOC into one with a fixed rate. These are welcome developments for those seeking the benefits of a revolving line of credit but with the predictability and security of fixed rates.
How Does a Fixed-Rate HELOC Work?
A fixed-rate HELOC allows you to borrow some or all of the funds from a revolving credit line at a fixed interest rate, a valuable option that can protect you from rising interest rates. Your interest rate doesn't change with a fixed-rate HELOC, which makes it easier to manage your monthly payments.
By contrast, when the interest rate rises on a variable-rate HELOC, your loan payments also rise.
Both types of HELOCS require you to put up your home as collateral. If you're unable to make your monthly payments for any reason, your lender could foreclose on your home.
Most lenders allow you to access up to 85% of your home's equity with a HELOC. The repayment term consists of two periods: the draw period and the repayment period.
- Draw period: Typically, this period lasts 10 years, during which you can withdraw money from your line of credit as needed up to your credit limit and make interest-only payments.
- Repayment period: You then enter into a repayment period, usually 20 years. You'll no longer be able to tap your credit line for funds, and you'll make principal-and-interest payments.
Remember, you're only responsible for paying interest on the amount you borrow, not your approved credit limit. So if you are approved for a $50,000 line of credit for a home renovation project, but you only use $30,000 of that, you'll only have to pay interest on the $30,000 balance.
Options and conditions for a fixed-rate HELOC vary by lender, such as:
- You may find a lender offering a new fixed-rate HELOC with rates that remain the same over the term of the loan.
- "Hybrid" HELOCs allow you to convert some or all of an adjustable-rate HELOC into a fixed one during the draw term.
- You may have the option to lock different fixed rates to the individual withdrawals you make on your credit line, with a cap on the number of rate locks.
- Expect a new HELOC to come with fees, such as an annual fee, application fee and loan origination fee.
- If HELOC interest rates drop in the future, you may be able to snag a lower rate by refinancing your debt with a new mortgage, home equity loan or HELOC.
Pros and Cons of a Fixed-Rate HELOC
As with any loan product, it's wise to weigh the advantages and disadvantages of a loan option to help you make an informed decision. The following are some of the pros and cons of a fixed-rate HELOC.
Pros of a Fixed-Rate HELOC
- A fixed rate simplifies your monthly budget and long-term planning.
- Locking your rate protects you against sudden or dramatic rate changes, saving you money if interest rates rise.
- Unlike a home equity loan, you only pay interest on the amount you draw, not the entire account balance.
- You may qualify for a tax deduction if you use proceeds from a HELOC to fund home improvements that increase your home's value.
Cons of a Fixed-Rate HELOC
- The availability of fixed-rate HELOCs is limited, although more lenders are beginning to offer them.
- It could have a higher initial interest rate to start than a variable-rate HELOC. If you plan on paying off your HELOC in the near future, the higher interest rate could offset any benefits of a fixed-rate HELOC.
- Fees vary by lender, but you may have to pay a nominal fee when you draw funds at a fixed rate or when you convert a variable-rate balance to a fixed rate.
- Your lender may cap the number of fixed-rate withdrawals, or "rate locks," on your account.
What to Consider Before Getting a Fixed-Rate HELOC
Fixed-rate HELOCS deliver numerous benefits, but they're not for everyone. Consider these factors as you contemplate getting a fixed-rate HELOC or another loan option.
Beware of hidden fees that can add up quickly. Before you commit to a particular fixed-rate HELOC option, it's essential to go through the contract and understand the fees your lender may attach to your line of credit.
In particular, ask your lender if there are any fees for converting your rate or penalties for paying your line ahead of schedule.
As you plan, pay attention to the rate forecast while considering your risk tolerance. If interest rates continue to rise, you may save money by locking in a fixed rate without fear of an unexpected jump in your rate and monthly payment. On the other hand, if interest rates drop, it may not be easy to convert back to an adjustable rate, especially if you recently moved to a fixed-rate HELOC.
A fixed-rate HELOC may make sense if you need to borrow a large amount of money. With a variable-rate HELOC, the more money you borrow, the more impact you may feel from a rate increase. Even a slight rate bump can trigger a significant increase in your monthly payment and strain your budget.
Your Credit Can Affect Your Ability to Get a HELOC
Whether you opt for a fixed-rate HELOC or another loan product such as a home equity loan, cash-out refinance or personal loan, your credit history will influence the approval process. Loan qualifications vary from one lender to another, but most will review your income, debt balances, payment history and scores.
Check your Experian credit report and access your credit score to see where your credit stands. If you anticipate borrowing money soon, improving your credit could increase your approval odds and help you qualify for favorable rates and terms.