Convertible HELOC Makes Budgeting Easier
Home Equity Lines of Credit, or HELOCs, offer a number of advantages.
They’re cheap to set up, and they’re easy to use.
But they also have a drawback — they come with variable interest rates, which means your payment can increase over the life of the loan, especially when the Federal Reserve hikes rates.
The convertible HELOC solves this problem.
HELOC loans come with two stages — the drawing or withdrawing phase, and the repayment period.
During the drawing phase, your minimum payment is only the interest due — you don’t need to pay down your balance at all. The drawing phase can last up to 20 years, depending on the loan’s term.
Your payment depends on your interest rate, which can change every month, and your loan balance.
Once the drawing phase ends, you enter the repayment period. This can range from ten to 20 years. During this time, you must pay off the entire balance. Your payments are calculated based on your rate that month and your balance, and they must be sufficient to pay off the loan within its term.
This can result in significant (and possibly unaffordable) payment spikes. If you’re concerned about this, consider a convertible HELOC.
How Do Convertible HELOCs Work?
Convertible HELOCs are lines of credit with an additional feature — the conversion option.
What this means is that at some point during the loan’s lifetime, you get the opportunity to convert your HELOC to a fixed rate, fully amortizing second mortgage.
- Some lenders allow you to convert your HELOC balance to a fixed-rate loan when the draw period ends and the repayment period begins.
- Others give you more than one opportunity. You can convert existing balances to fixed-rate financing any time during your loan’s life.
- Your new fixed rate is generally the prevailing fixed rate for that loan term, plus a premium for the conversion.
- The new rate may not be a bargain. One homeowner who was paying under four percent with a variable rate loan found that converting her loan would get her a nine percent fixed rate.
- Some convertible HELOCs extend your repayment. For instance, you could start with a 25-year HELOC with a 15-year draw period. When the draw period ends, you might be able to convert your remaining balance to a 30-year fixed loan.
If you already have a HELOC, check your paperwork. Your loan may allow you to convert to a fixed rate. Note that there may be fees involved.
Convertible HELOC: Questions You Should Ask
When shopping for a HELOC with a conversion option, ask lenders these questions:
- Is there a charge for the conversion? If so, how much is it?
- Will I be able to use the remaining credit available on the line after a conversion?
- Does the loan convert to a new fixed loan (for example, with a 30-year term), or is the balance amortized over the remaining term of the existing loan?
- How many times can I convert?
- How often can I convert?
- What determines the new fixed interest rate?
See what the loan’s fixed rate would be if you were converting it now. You might not find the conversion option worth exercising if the rate would be too high.
Alternatives To Converting Your HELOC
If you have a convertible HELOC with a balance, make sure the new rate is worth having. You might be better off with one of these options:
- Refinance your HELOC to a fixed-rate second mortgage. You’ll pay the prevailing fixed rate without the conversion premium. However, there are costs involved.
- Refinance your HELOC and first mortgage into a new first mortgage. Your interest rate should drop, and the rate should be significantly lower than that of second mortgages.
Understand that the new loan would probably be considered a “cash-out” refinance, and lenders typically impose some risk-based fees. If your new loan balance will exceed 80 percent of the current property value, it will be harder to get approved, and you’ll probably have to pay for mortgage insurance.
Your Blended Rate: An Essential Calculation
Before wrapping a first and second mortgage into a new first mortgage, you should know what you’re paying on the total mortgage balances.
This calculation is called your “blended rate.” And here’s how you do it.
- Determine the percentage of your total mortgage balances each loan comprises. For instance, if you have a $300,000 first mortgage, and a $50,000 second mortgage, your first mortgage makes up 86 percent of the total ($300k / $350k = .86), and your second mortgage makes up 14 percent.
- Multiply each percentage by the interest rate. If the rate for the first mortgage is 4.25 percent, you’ll adjust this rate to 3.66 percent (.0415 * .86 = .0366655). If the second mortgage rate is 8.5 percent, you’ll adjust it to 1.19 percent (.085 * .14 = .019).
- Add the two adjusted rates together to get the blended rate. In this case, it’s 4.85 percent (.0119 + .0366 = .0485).
Now that you know what you’re really paying, you can compare that to any cash-out refinance offers you receive.
What Are Today’s Mortgage Rates?
Current mortgage rates depend on several factors — your strength as a borrower, the product you choose to pay off your HELOC, and how effectively you shop for a loan.