A home equity line of credit (HELOC) is a revolving credit line secured by your home. HELOCs can be a convenient source of cash, but it’s important to weigh the cost of borrowing. Before applying for a HELOC, you’ll want to understand how interest is computed.
For instance, do HELOCs compound interest? Or do lenders use simple interest instead? The short answer is that it depends on the lender and your HELOC terms. Understanding the difference between compound and simple interest on a HELOC can help you estimate what you’ll pay.
Key Points
• HELOC interest applies only to the borrowed amount, not the total credit limit.
• Interest is usually calculated daily during the draw period.
• HELOC rates are determined by an index rate plus a margin.
• Variable-rate HELOCs have rate caps and floors to limit fluctuation.
• Additional payments can decrease interest costs and shorten repayment time.
What Is HELOC Interest?
HELOC interest is the price you pay to borrow. Lenders charge interest for the portion of your credit limit you use. If you’re approved for a $50,000 HELOC, for example, but only access $30,000 of your credit line, you’d only pay interest on that amount.
That’s a key difference from a home equity loan, which puts a lump sum of money in your bank account and charges interest on that sum from Day One. With a HELOC, you only pay interest on the amount borrowed, and you can borrow in increments vs. all at once.
Is it possible to get a HELOC with zero interest? Yes, but there’s usually a catch. A 0% APR may apply for a set period, after which your HELOC interest rate increases. That’s similar to how a 0% APR credit card works.
Recommended: What Is a Home Equity Line of Credit(HELOC)?
Understanding HELOC Interest Rates
How does interest work on a HELOC? Let’s go back to the difference between simple and compound interest.
Simple interest is calculated as a percentage of the principal, or the original amount borrowed. So, essentially the math would work like this:
Compound interest, meanwhile, is calculated on the principal and the accumulated interest. Between the two, a compound-interest loan is typically more expensive.
Knowing how HELOC interest is calculated matters when comparing HELOC options. You want the monthly payments to be affordable, of course, but it’s also to your advantage to minimize the amount of interest you pay. (That’s also why you’ll want to look carefully at mortgage rates when considering any type of home loan, including a home equity line of credit.)
Factors Influencing HELOC Interest Calculations
If you’re shopping for a HELOC, it helps to understand what influences the rate a lender offers you. Rate decisions largely hinge on two things: market conditions and your creditworthiness. Here’s more on how to calculate interest on HELOC balances.
Variable vs. Fixed Interest Rates
Like home loans, HELOCs can have fixed or variable rates. Here’s what each one means for you:
• Fixed rates don’t change over the life of the loan term. That makes it easier to estimate your interest costs, based on how much of your HELOC you use. And you’ll get the benefit of a predictable monthly payment.
• Variable rates can increase or decrease over time. When variable rates increase, your monthly payment — and your HELOC cost — goes up. If rates drop, then your payment and total interest costs go down. It’s common for a variable rate HELOC to have an initial fixed-rate period, after which the interest rate can adjust at regular intervals.
So is a fixed-rate or variable-rate HELOC better? If you prefer predictable payments, you might go with a fixed-rate HELOC. Keep in mind, however, that fixed rates may end up being higher than variable rates over time, depending on market conditions.
Index Rates and Margins
HELOC rates are determined using an index rate and a margin. An index rate is a benchmark rate that acts as a guide for setting rates on loans and lines of credit.
Many HELOC lenders rely on the prime rate as a benchmark, which is the rate that banks offer to their most creditworthy customers. Other index rates include the LIBOR (London Interbank Offered Rate) and the Treasury Bill (T-Bill) rate.
Margin, meanwhile, is an additional percentage that’s added to the index or benchmark rate. So, how is HELOC interest calculated using an index rate and margins? The formula looks like this:
Say the prime rate today is 7.50%. Your HELOC lender adds a margin of 1% to 1.50% to that rate. That means HELOC rates would range from 8.50% to 9.00%.
Interest Rate Caps and Floors
In HELOC terms, a rate cap represents the maximum rate you’ll pay for a home equity line of credit. A floor, meanwhile, is the lowest HELOC rate a lender offers. It’s important to be familiar with these terms if you’re considering a variable-rate HELOC.
Why? Because if rates rise, you don’t want your HELOC rate to increase without limits. Rate caps draw a line in the sand on how much interest the lender can expect to collect from you. Rate floors, on the other hand, protect the lender if rates drop by allowing them to collect a minimum amount of interest.
Before signing off on a variable-rate HELOC, it’s helpful to review the rate floor and rate cap, so you have perspective on how little or how much your line of credit might cost over time.
Calculating Interest During the Draw Period
HELOCs have two phases. The first is the draw period. This is when you can access your line of credit. A typical draw period for a HELOC is five or 10 years.
Here’s how to calculate interest on HELOC balances during the draw period.
Daily Interest Calculation
It’s not unusual for HELOC lenders to calculate interest daily during the draw period. Here’s how you can do the math.
• Divide your APR by 365 (number of days in the year)
• Multiply the result (your daily interest rate) by your balance to find your daily interest accrual
For example, say you owe $50,000 to a HELOC at 5.00%. If you plug in the numbers, the math looks like this:
Note that some lenders use 360 instead of 365 to calculate your daily interest rate. That number assumes that every month has 30 days.
Impact of Outstanding Balance
Your average daily balance affects daily interest calculations. If your balance goes down (or up), that can change the outcome.
For example, let’s say you performed the above calculation on the first day of the month. But on the 15th, you make a $2,000 payment to your HELOC. Now your balance is $48,000 and the math looks like this:
Lenders use the daily interest calculation because it allows them to factor in new draws or payments at any point in time. At the end of the month, all your daily interest accruals are added up to find your monthly interest total.
Payment Structures
With most HELOCs, you begin making principal and interest payments once you enter the repayment period. Again, at this point you won’t be able to make any new withdrawals from your HELOC; you’re only paying it off. A typical repayment period might be 15, 20, or 25 years.
HELOC lenders may expect you to make minimum payments during the draw period, however. For instance, you might make interest-only payments to cover the interest that’s accrued over the month.
Calculating Interest During the Repayment Period
How is interest calculated on HELOC balances in repayment? In this phase of your HELOC’s lifespan, your balance only goes down, not up. Interest calculations work the same as they would for any other mortgage, including a home equity loan or a first mortgage. You can plug your balance owed and interest rate into a HELOC repayment calculator to estimate your monthly payments and total cost.
Amortization of Principal and Interest
Amortization refers to the way your payments are allocated between the principal and the interest. Once you enter repayment, your lender should give you an amortization schedule showing how much of your monthly payment goes to each one over time.5
As with other types of mortgage loans, you’ll pay more toward interest in the early part of the repayment term. Some of your payment goes to the principal, reducing the amount that interest is calculated on. By the time you get down to your last payment, almost every penny should go to the principal.
Changes in Monthly Payments
If you took out a fixed-rate HELOC, your payments won’t change during the repayment term. Your payment would be determined by how much you borrowed and your interest rate.
With a variable-rate HELOC, the monthly payments could change if your rate changes during the repayment term. That means your HELOC could become more or less expensive, depending on which way rates move.
Effect of Additional Payments
The number of payments you make to a HELOC is determined by your repayment term. For example, if you have a 10-year repayment period, your amortization schedule should show 120 payments total.
Making extra payments against the principal you owe on a HELOC could reduce your total interest cost and help you repay the line of credit faster. When you chip away at the principal, that shrinks the amount that the lender uses to calculate interest.
Recommended: HELOC Loan Guide
Strategies to Manage HELOC Interest Costs
HELOCs can be a useful financial tool, and it’s to your advantage to find ways to keep interest to a minimum. Here are some strategies for reducing your overall cost.
Making Extra Principal Payments
As mentioned, making extra principal payments reduces the balance that interest is calculated on. If you’re considering this strategy, there are a few ways to do it.
• Pay biweekly. Biweekly payments can add one full extra payment to your HELOC each year. It might be worth looking into whether your lender offers this option.
• Lump sum payments. If your lender allows lump-sum payments, you might leverage your tax refund or a year-end bonus to pay down a chunk of your HELOC debt.
• Round up. Rounding up your monthly payment is a small but impactful way to save on interest. For example, if your monthly payment is $873 you could pay $875 or $880 instead to knock a few extra bucks off the balance.
It’s also worth exploring rate discounts if you can’t pay extra to the principal. For example, you might be able to get a rate cut if you get a HELOC and a checking account at the same bank, or enroll in autopay for payments. Even a discount of 0.25% could make a difference in what you pay over time.
Monitoring Interest Rate Changes
If you have a variable-rate HELOC, then it’s smart to pay attention to interest rate shifts. If you notice that there are rumblings about a potential rate hike, for instance, you may need to prepare yourself to see a higher monthly payment on your next statement.
Rate cuts, on the other hand, could create an opportunity to save on interest. Refinancing into a new loan could help you secure a lower rate, for instant savings.
Refinancing Options
It’s possible to refinance a HELOC — you just need to shop around and find the right lender. Refinancing a HELOC means you take out a new loan to replace your existing line of credit. You then make payments toward the new loan going forward.
HELOC refinancing options include:
• A new HELOC
• A home equity loan
• A personal loan/line of credit
You could also get a new home loan to pay off your combined first mortgage and HELOC. Mortgage preapproval can give you an idea of what rates you’re likely to qualify for. For instance, FHA loans allow you to apply for a cash-out refinance that you could then use to pay off your existing mortgage debt.
Refinancing could make sense if you can get a lower rate than you’re paying now. You might also look into refinancing your HELOC if you’d like to move from a variable rate to a fixed rate.
The Takeaway
Understanding how HELOC interest is calculated is helpful if you plan to leverage your equity for cash. It’s also a good idea to shop around and compare HELOC rates to see what lenders are charging, and to explore fixed- vs. variable-rate HELOC options.
SoFi now partners with Spring EQ to offer flexible HELOCs. Our HELOC options allow you to access up to 90% of your home’s value, or $500,000, at competitively lower rates. And the application process is quick and convenient.
FAQ
Can I convert a variable-rate HELOC to a fixed-rate?
It’s possible to convert a variable-rate HELOC to a fixed-rate. You’ll need to refinance your HELOC into a new line of credit unless your lender offers a simpler conversion option.
How does the prime rate affect my HELOC interest?
If your lender uses the prime rate to set HELOC rates, then changes to that benchmark can affect what you pay for your line of credit. That assumes that you have a variable-rate HELOC. If you have a fixed-rate HELOC, you’ll always pay the same rate, regardless of what changes occur with the prime rate.
Are there penalties for paying off my HELOC early?
Some lenders charge prepayment penalties or early termination fees for paying a HELOC off early. If your lender charges these fees, that should be spelled out in your loan agreement.
How can I estimate my monthly HELOC interest payments?
A HELOC repayment calculator can help you figure out the total that you’ll pay monthly. You can check your amortization schedule to see how much of your payment goes to interest each month over the life of the repayment term.
What is the difference between interest-only and principal-plus-interest payments?
Interest-only payments are payments toward the interest that accrues on a loan or line of credit. Principal-plus-interest payments let you repay the principal amount you initially borrowed plus the interest the lender charges. HELOCs may offer interest-only payments in the draw period, followed by principal-plus-interest payments during the repayment term.
About the author
Rebecca Lake
Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.
Photo credit: iStock/milko
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