How Is Interest Calculated on a HELOC?

A Home Equity Line of Credit (HELOC) allows homeowners to borrow against their property’s equity. It functions as a revolving line of credit, similar to a credit card, providing access to funds up to a predetermined limit. HELOCs are typically used for substantial expenses like home improvements, debt consolidation, or emergencies. Unlike a traditional loan, a HELOC offers the ability to borrow, repay, and re-borrow funds as needed throughout its initial phase.

Key Components of HELOC Interest Rates

HELOC interest rates are predominantly variable, fluctuating throughout the loan’s life. This variability is tied to changes in broader market conditions. The interest rate is determined by combining two primary elements: an index and a margin.

The index is a benchmark interest rate reflecting general economic trends. The most common index for HELOCs in the United States is the Prime Rate. This rate is influenced by the federal funds rate, the target rate set by the Federal Open Market Committee (FOMC) of the Federal Reserve. Banks typically adjust their Prime Rates in response to FOMC decisions. As the Federal Reserve adjusts its monetary policy, the Prime Rate, and consequently HELOC rates, can move up or down.

The second component, the margin, is a fixed percentage added to the index rate by the lending institution. This margin remains constant throughout the HELOC’s term. For example, if the Prime Rate is 8.50% and a lender’s margin is 2%, the HELOC interest rate would be 10.50%. The specific margin offered can vary based on factors such as creditworthiness, loan-to-value ratio, and lender policies.

Some HELOCs include interest rate caps and floors, which limit how much the variable rate can change. A cap sets a maximum rate, protecting the borrower from excessive increases. A floor establishes a minimum rate, ensuring the lender receives a certain level of interest even if market rates decline. These measures are outlined in the loan agreement and provide predictability within the variable rate structure.

Calculating Your Monthly Interest Payment

Your monthly interest payment on a HELOC is based on the outstanding balance drawn from your credit line, not the total approved credit limit. Interest is only charged on the money you have actually used. Most lenders calculate HELOC interest using the average daily balance method. This involves summing the outstanding balance for each day within a billing cycle and then dividing that total by the number of days in the cycle to arrive at the average daily balance.

To determine the daily interest charge, the annual interest rate is converted into a daily periodic rate. This is typically done by dividing the annual interest rate (composed of the index plus the margin) by 365 or 360, depending on the lender’s terms. For instance, if the annual interest rate is 7.5%, the daily rate would be 0.075 divided by 365. This daily rate is then applied to the average daily balance to calculate the interest accrued each day.

The total interest for the billing cycle is found by summing these daily interest charges. For example, if your average daily balance for a 30-day billing cycle was $10,000 and your daily periodic rate was 0.0205% (equivalent to a 7.5% annual rate), your total interest for that month would be approximately $61.50 ($10,000 x 0.000205 x 30 days). Any payments made during the billing cycle reduce the average daily balance, which in turn lowers the interest charged.

How Interest Varies During HELOC Phases

A HELOC typically progresses through two distinct phases: the draw period and the repayment period. Each phase has a different structure for interest payments and their impact on the overall loan.

During the draw period, which commonly lasts 5 to 15 years, you can access funds from your approved credit line as needed. In this phase, many HELOCs allow for interest-only payments. This means your minimum monthly payment covers only the accrued interest, with no principal reduction required. While this offers lower initial payments and financial flexibility, the principal balance remains unchanged unless you pay more than the minimum.

Once the draw period concludes, the HELOC transitions into the repayment period, which can last up to 20 years. During this phase, you can no longer draw new funds. Instead, your monthly payments will increase significantly as they now include both principal and interest on the outstanding balance. The loan is amortized over the repayment term, meaning payments gradually pay down the principal balance along with the interest. This shift can lead to a substantial increase in monthly obligations, so planning for this transition is important.