How Is Interest Calculated on a HELOC?
Understand how interest is calculated on a Home Equity Line of Credit (HELOC), from rate components to payment impact.
A Home Equity Line of Credit (HELOC) offers homeowners a flexible way to access the equity built in their property. It functions as a revolving line of credit, much like a credit card, but is secured by the home itself. This financial tool allows individuals to borrow funds as needed up to a set limit, making it suitable for various expenses such as home improvements or consolidating higher-interest debt. Understanding how interest is calculated on a HELOC is important for borrowers to manage this type of credit effectively.
Key Elements of HELOC Interest Rates
HELOCs feature variable interest rates, meaning the rate applied to the outstanding balance can change over time. This variability stems from two components: an index rate and a margin. These elements combine to form the Annual Percentage Rate (APR) that borrowers pay.
The index rate is a fluctuating benchmark reflecting broader market conditions, with the U.S. Prime Rate being the most common index for HELOCs. This rate is influenced by the Federal Reserve’s monetary policy decisions. The Secured Overnight Financing Rate (SOFR) has replaced LIBOR as another index.
Lenders add a fixed percentage, known as the margin, to the index rate to determine the HELOC’s interest rate. This margin is set at loan origination and remains constant throughout the life of the loan. Factors like a borrower’s creditworthiness and the home’s loan-to-value (LTV) ratio influence the specific margin offered.
The sum of the index rate and the margin constitutes the HELOC’s APR. For instance, if the Prime Rate is 8.50% and the lender’s margin is 2.00%, the HELOC’s APR would be 10.50%. HELOC agreements often include interest rate caps to provide predictability for borrowers. These limits prevent the interest rate from increasing indefinitely, specifying periodic caps and a lifetime cap that sets the absolute maximum rate over the loan’s duration.
Methods for Calculating Interest
HELOC interest is calculated using the average daily balance method. This approach tracks the credit line’s balance each day throughout the billing cycle. Daily balances are summed and divided by the number of days in the billing cycle to arrive at the average daily balance.
Once the average daily balance is determined, the current Annual Percentage Rate (APR) is applied to calculate the interest accrued. The APR is converted into a daily periodic rate by dividing it by 365. This daily rate is then multiplied by the average daily balance to find the daily interest charge. Daily interest charges are summed for the entire billing cycle to determine the total interest owed for that period.
For example, consider a HELOC with an APR of 7.30% and a 30-day billing cycle. If the average daily balance is $10,000, the daily periodic rate would be 0.0730 divided by 365, which equals 0.0002. Multiplying this by the $10,000 average daily balance yields a daily interest charge of $2.00. Over a 30-day cycle, the total interest accrued would be $60.00. HELOC interest is simple interest, calculated only on the outstanding principal balance, not on previously accrued interest.
How Payments Affect Interest Accrual
Interest on a HELOC is calculated based on the outstanding principal balance, so any payment that reduces this balance will directly lower the interest accrued in subsequent periods. Making payments beyond the minimum required can reduce the overall interest paid over the life of the loan.
HELOCs have two distinct phases: the draw period and the repayment period. During the draw period, which lasts between 5 and 10 years, borrowers can access funds up to their credit limit. Payments during this phase are often interest-only, meaning the principal balance may not decrease unless additional payments are made. Making only minimum interest-only payments means the principal balance remains unchanged, leading to prolonged interest accrual on the original borrowed amount.
Once the draw period concludes, the repayment period begins, lasting 10 to 20 years. During this phase, borrowers can no longer draw new funds, and payments become fully amortized, meaning they include both principal and interest. This structure ensures the outstanding balance is systematically reduced and paid off by the end of the loan term. The shift from interest-only payments to principal-plus-interest payments can result in higher monthly payments.
Making payments above the minimum, especially during the draw period, directly reduces the principal balance. This practice not only lowers the interest accrued daily but also decreases the total interest paid over the loan’s lifetime. Even small, consistent additional principal payments can lead to savings and help pay off the HELOC sooner.