How Is HELOC Interest Calculated?

A Home Equity Line of Credit (HELOC) is a flexible loan that allows homeowners to borrow against the equity they’ve built in their property. One key aspect of a HELOC that borrowers need to understand is how interest is calculated, as this impacts both the cost of borrowing and repayment plans. But what makes HELOC interest different from traditional loan interest calculations?

How Does HELOC Interest Work?

Let’s explore the process, dissect the variables, and unravel how lenders calculate HELOC interest.

Variable Interest Rates
HELOCs generally feature variable interest rates, which fluctuate based on a financial index—most commonly the prime rate—plus a margin set by the lender. When the prime rate rises or falls, the interest rate on the HELOC adjusts accordingly.

The formula for calculating a HELOC’s interest rate is:
Interest Rate = Prime Rate + Lender’s Margin

For example, if the prime rate is 6.5% and the lender’s margin is 1%, the HELOC interest rate will be 7.5%.

Calculating Daily Interest
HELOC interest is typically calculated daily based on the outstanding balance. The lender divides the annual interest rate by 365 to determine the daily interest rate. This daily rate is applied to the current balance to generate the daily interest charge.

Formula for Daily Interest:
Daily Interest = (Outstanding Balance × Annual Rate) ÷ 365

Example:

Loan Balance: $100,000
Annual Interest Rate: 7.5%
Daily Interest Rate: 7.5% ÷ 365 = 0.000205
Daily Interest: $100,000 × 0.000205 = $20.54

If the balance remains at $50,000 for 30 days, the total interest for that month would be:
$20.54 × 30 = $616.20

Isn’t it reassuring to know that you only pay for what you use, rather than the total credit limit?

How Draws and Payments Affect Interest

Since HELOCs have a revolving credit structure, the outstanding balance changes as you withdraw funds and make payments. Each time you draw from the HELOC, the new balance becomes the basis for interest calculation. Similarly, any payments reduce the balance, thereby lowering the interest charged.

This dynamic calculation method offers flexibility, but it also means borrowers need to monitor their balances closely to avoid accruing more interest than expected.

Think of your HELOC like a faucet—each time you turn it on, water (or debt) flows, and each drip adds a bit more to your bill.

Payments During the HELOC Draw Period

During the draw period, most HELOCs require interest-only payments on the outstanding balance. This keeps monthly payments low, but it also means you’re not reducing the principal unless you make additional payments.

For example, if you borrow $30,000 at an interest rate of 7%, your monthly interest payment would be:

Daily Interest: (7% ÷ 365) × $30,000 = $5.75
Monthly Interest: $5.75 × 30 = $172.50

In this case, your payment for the month would be $172.50, and the principal balance would remain at $30,000 unless you make extra payments toward it.

Interest During the HELOC Repayment Period

Once the HELOC transitions from the draw period to the repayment period, the borrower begins repaying both principal and interest. Depending on the terms, this may involve fixed monthly payments for the HELOC repayment schedule that adjusts based on the balance and interest rate.

If the interest rate remains at 7% and the repayment period is 15 years, the lender will calculate monthly payments using a loan amortization formula. These payments reduce both interest and principal, gradually paying off the balance over time.

Isn’t it easier to manage debt when you know how much your payments will be and when they will end?

Factors That Influence HELOC Interest Costs

Several factors affect how much interest you’ll pay over the life of a HELOC:

Credit Score: Borrowers with higher credit scores typically receive lower margins, resulting in more favorable interest rates.
Prime Rate Changes: Since HELOCs have variable rates, increases in the prime rate directly impact the cost of borrowing.
HELOC Lender Fees: Some lenders charge annual fees or transaction fees, which can increase the overall cost of the HELOC.
Loan-to-Value Ratio (LTV): Lenders may offer better rates if you have a lower LTV ratio, indicating more equity in your home.

How to Minimize HELOC Interest Costs

Managing your home equity line of credit effectively can help you reduce interest expenses over time. Here are some strategies:

Make Extra Payments: Paying down the principal balance reduces the amount on which interest is calculated.
Lock in a Fixed Rate: Some lenders allow borrowers to convert part or all of the HELOC balance to a fixed-rate loan, offering stability in a fluctuating market.
Monitor Rate Changes: Keep an eye on changes in the prime rate to understand how it affects your loan.
Shop Around for the Best HELOC Terms: Compare lenders to find the most competitive rates and margins.

FAQ on HELOC Interest

How Does a HELOC Loan work?

A HELOC is a home equity line of credit that provides a revolving line of credit like a credit card. This unique line of credit allowing borrowers to withdraw money as needed during the HELOC draw period, which typically lasts 5 to 15 years. HELOCs are highly revered because you only pay interest on the amount you access. After the draw period, the credit line enters the HELOC repayment phase, where both principal and interest must be repaid over a set period, often 10 to 20 years.

What is an interest only HELOC?

An interest-only Home Equity Line of Credit lets you borrow funds against your home’s equity while only requiring interest payments on the borrowed amount during the initial draw period. This interest only period usually lasts between five and 15 years.

Does HELOCs interest​ compound?

Yes, a home equity line of credit is a revolving credit with compounding interest​. There are some HELOC lenders that use simple interest when the borrower is choosing a fixed interest rate option rather than compound interest when calculating adjustable rate payments. However, many lenders continue to utilize compounding interest, where interest accrues on both the principal and previously accumulated variable interest rates.

Is HELOC interest tax deductible​?

The HELOC interest paid may be tax-deductible if it complies with IRS guidelines. The same rules apply to both home equity loans and equity lines of credit meaning the total loan amount or credit limit must stay within the established limits, and the funds must be used to improve or rehabilitate the home that HELOC is secured by.

How does the HELOC repayment work?

The home equity line of credit features an option for borrowers to make interest-only payments during the draw period, followed by principal and interest payments once the repayment period begins. The repayment period for most HELOCs begins after 10 or 15 years. These days most borrower are requesting a fixed rate repayment period for the HELOC, but many lenders still push the variable rate HELOC during the repayment period.

Takeaways on How to Calculate HELOC Interest

Understanding how HELOC interest is calculated helps borrowers make informed financial decisions. Since interest is calculated daily and based on a variable rate, the cost of borrowing can fluctuate throughout the life of the loan. Knowing the impact of draws, payments, and changing balances allows you to better manage your debt and minimize interest expenses.

Think of a HELOC as a journey—you can control the path by monitoring your spending and payments, ensuring you reach your financial destination smoothly.

By planning carefully and managing your balance effectively, you can use a HELOC to fund important projects while keeping interest costs under control.

References:

Consumer Financial Protection Bureau (CFPB). (2023). What to know before getting a HELOC.

US News & World Report. (2023). Understanding HELOC interest rates.

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