How Do HELOC Payments and Interest Work - What you NEED to Know

Are you interested in a HELOC, but you have no idea what you're getting yourself into in regards to the payments? Interest only, variable rates, draw period, repayment period. It all sounds so confusing, but you will not be confused after watching this video, I promise you. Let's get to it. What is up, everybody? Welcome back to the channel. If you didn't already know, my name's Jay Costa. I'm a real estate investor, agent, and builder here in Northern New Jersey. And if you get value after watching this video, please smash that like button down below and also consider subscribing because we are building a tight-knit community here of like-minded individuals who are looking to build wealth in real estate. And we talk a lot on this channel about specifically using your home equity, using a HELOC, in order to build that wealth in real estate quicker and easier than you would be able to without. So if that interests you, definitely consider subscribing and hit that notification bell so you can stay up to date with our weekly videos. But in this video, we're going to go over how HELOC payments work. And this is frankly one of the most common questions that I get from you guys in that comment section down below. And if you haven't checked out that comment section, please do so right now. Love to start a conversation with you guys. Love to see what you guys are doing and using your home equity on. Okay? So if you have a home equity line of credit already, drop a comment in the comment section down below and let me know what you're using it on. But I'm also surprised at the lack of information on YouTube and on the internet in general about how these HELOC payments work. So that's what we're going to go over today. How HELOC payments work. I'm going to explain to you how the interest rates are calculated, how the payments are calculated, how the payments will change from one period of the HELOC to the next. And lastly, I'll share with you my four rules on using a HELOC. That way you can make a decision on whether or not you should even be using your HELOC on what you're planning on buying or using it for in the first place. So first things first, what is a HELOC? Well, a HELOC stands for home equity line of credit, and it's basically a revolving credit line based on the equity that you have in your home. A HELOC is a variable interest rate loan, so the interest rate can and will change. So where does this interest rate come from? Well, let's go over that right now. In order to understand this, you need to know three main terms. First is what's called the federal funds rate. The federal funds rate is set directly by the Federal Reserve of the United States. When you see Jerome Powell's face all over CNBC, that's when the Federal Reserve has just met and that's when they set the federal funds rate. And right now, the federal funds rate as of July 2024 is 5.5%, and it's been this for quite some time. Now, does that mean that your HELOC has an interest rate of 5.5%? Absolutely not. What you need to know next is what's called prime rate. Prime rate is very simple to understand. It is the federal funds rate plus 3%. So that is right now 8.5%. So does that mean that that's your HELOC interest rate, 8.5%? Absolutely not, because the HELOC lender needs to make money off of you somehow. So what they do is they add on what's called a spread or a margin, and the spread or the margin will differ depending on the lender and depending on you and your application, how your credit is, what your income is, your debt to income, how much money you're looking to take out of your home equity. It'll all depend on the application that you submit to them. But generally speaking, they're about anywhere from 1% to 3%. So if the spread is 2% on your HELOC, you basically take the prime rate, which is 8.5%, plus 2%, and that gives you 10.5%. So now that we know what the interest rate could be on a home equity line of credit, generally speaking, how does this affect the payments on the HELOC that you're going to have to pay? Well, first, before we get into the numbers, you need to know that a HELOC is basically split into two different periods. The first period is what's called the draw period. This is generally for 10 years, the first 10 years of your HELOC. And this is when you can draw from your HELOC as well as pay off your HELOC as you see fit. And during the draw period, you're only obligated by the lender to pay interest only. You don't have to pay principal at all. So this means that your payment, your minimum payment required, will be somewhat low. But it's important to realize and understand that this is interest only. If you're making those minimum payments, your balance will stay the same. It's not going to go down for the first 10 years. Now, after that 10 year draw period, it then converts into what's called a repayment period, which is exactly what it sounds. This is when the lender requires you to start repaying the loan. In order to do this, they convert it into a more amortized loan on an amortization schedule based on generally usually about 15 years. And during this repayment period, your balance is set. You start paying it down, but you cannot draw from the HELOC any longer. So how is the interest payment calculated on a HELOC? Well, first thing you need to know is that a HELOC lender doesn't use the balance at the end of each month in order to calculate the interest owed. It actually uses what's called an average daily balance, which is exactly what it sounds like. It's the average balance per day that you have on the HELOC. Since a HELOC, you can draw and pay back as you see fit. The balance changes day to day. So the HELOC lender sees this as the best possible way to collect the interest that's owed on the money. For instance, if you take $50,000 out of your HELOC and just keep it at $50,000 the entire month, your average daily balance is going to be $50,000. But let's say, hypothetically, you take out $75,000 and hold a $75,000 balance the first half of a month, and then the next half of a month, you actually pay it off down to $25,000. Then the average daily balance, half of the month you had at $75,000, half of the month you had at $25,000, the average daily balance is going to be $50,000. So this is how you calculate your interest payment when it's interest-only loans during the draw period. First, you take your interest rate that you agreed to with the HELOC lender. So let's say you agreed to an 11% interest rate with the HELOC lender. You basically divide that by 365 for, obviously, each day of the year. Then you take your average daily balance and you multiply it by that interest rate per day. So your interest rate's 11%, and the interest rate per day is going to be about 0.0301%. Once again, that is the percentage of interest you're paying on your average daily balance per day. So let's keep the same $50,000 figure that we used prior. You multiply that $50,000 by the 0.0301%, which is your interest rate daily. And that brings you to just over $15 per day that you're going to be paying on interest. And obviously, you could take that $15, multiply it by 30 or 31 for the month, and that brings you to your monthly payment, in this case, $451, give or take. Once again, reminder, this is interest-only. This is during the draw period. So you pay that $451, and your balance is still $50,000 at the end of the month. After that, after the 10 years of doing this, then it converts into the repayment period, and that's when it amortizes out over 15 years. In order to calculate this, the easiest way, honestly, is to just go online and search for HELOC payment calculator, put in all your information, and it'll give you the numbers right in front of you. Using these same numbers, that $451 or so per month interest-only payment will then convert to a $568 per month interest and principal payment once you're in that repayment period. So it's very important to keep in mind that your interest-only payment will go up once that draw period is over. And just like any amortized loan, the longer you go through that repayment period, the more principal you're paying off and the less interest you're paying off, very similar to a mortgage. Now, it's important to remember and realize that there's a lot of different varying factors in regards to using a HELOC. These numbers were very, very elementary because it's, frankly, almost impossible to explain to you on a YouTube video how the payment is calculated and works when your balance is changing every day or your interest rate is changing every few months. That is just something that you're going to have to keep in mind when trying to figure out what you're using your HELOC for and if it's worth it using a HELOC on what you're planning on using for in the first place. And because of these variables, both the variable interest rate as well as the payment going up after the draw period is over, it's very important to only use your HELOC on short-term debt. And that brings me to my four main rules on using a HELOC. My number one rule is that it must be short-term because the HELOC is a variable interest rate, as well as the fact that a HELOC lender can call back your balance at any time for any reason, including market conditions out of your control. The longer you hold a HELOC balance, the more risk you're taking and the more you're putting your primary residence on the line. Number two, you need to have a clear exit strategy going in. This means that before using your HELOC, you need to have a plan on paying it back. One of the best ways to use a HELOC, in my opinion, is real estate investing on a fix and flip project because it is short-term inherently and it also inherently has a clear exit plan when you go sell the property. You can also use it for a long-term rental property, but only if you're using the BRRRR method. I've made a video on this in the past. I'll put a link in the description box down below, as well as up in the corner here. Third, I would say never over leverage and never take out money from your HELOC that you don't have some other way to pay it back. This could be in a retirement account, a brokerage account, anywhere. You need to have the money in order to pay it back because it's very important to realize that the HELOC lender, like I said, can draw that or can call that balance back at any time. And lastly, only use your HELOC on something that's either gonna make or save you money. That means you're not using it on home improvements. You're not using it on consumer debt to go buy a car or a boat. Don't, don't, don't use your HELOC for these things. I promise you, you're gonna end up in a world of trouble and most likely lose your home that you and your family live in. And that is what we want to avoid. There's a lot of people on YouTube that explain how like HELOC, using a HELOC and using your home equity, oh, the equity is just sitting there. It's your money, just use it. It's not your money. You don't own the house yet until you, until there's no loan at all on the property, okay? Generally speaking, if you're getting a HELOC, you still have a mortgage. Please, please only use the HELOC on something that's either gonna make or save you money. And even save you money, you have to be very cautious of as well. I've made videos about this in the past, paying off student loans, paying off consumer debt in order to, you know, save on the interest. Yes, by the numbers, sometimes that can be a good idea and save you money, but you need to be aware and you need to be honest with yourself that you're not just going to get yourself in that same consumer debt that you did in the first place. When you see that $0 credit card balance, are you gonna go, you know, treat yourself to a whatever you buy, whatever's your vice, right? You need to be honest with yourself and make sure, be very disciplined that you don't get yourself in that position. But frankly, I think if you're watching this video and you're looking up these topics on YouTube, you're probably a more disciplined person. So just, like I said, keep in mind, be honest with yourself what you're going to use the HELOC for and make sure it's going to make or save you money. That is it for today, guys. Thank you so much for watching. If you like this content, you will love my custom playlist on HELOCs and HELOC investing. I'll put a link in the description box down below as well as up in the corner right here. Drop a comment in the comment section down below about any questions that you may have on how HELOC payments work. I would love to start a conversation as always with you guys, and I will see you next time.