HELOCs calculate interest like a credit card: based upon average daily balance.
Conventional mortgages calculate interest on a simple basis.
Interest calculation formulas used:
HELOC: Daily rate (note rate/365) x average daily balance x days in the month
Conventional mortgage: Note rate/12 x balance on the 1st
Interest over time example:
Starting balance of $150,000
Conventional note rate 5.5%
HELOC annual rate of 5.5%
To complete this side by side interest comparison, a principal and interest payment is applied on the 1st of every month. The conventional mortgage assumes a 30 year amortization. This table shows the additional cost a HELOC would carry if the same exact monthly payment were applied.
The flaw in this assumption is the amount of payment. In the real world, often only the interest payment is applied each month on HELOCs. The key is understanding that interest is calculated daily based upon the outstanding balance. It is for this reason that HELOC interest calculation can work both for and against the borrower. If principal payments are made more regularly than once per month, it can be of benefit to have a daily interest calculation completed. However, if principal payments are made monthly or less frequently, the total interest charge is more than a conventional mortgage at the same rate and same base level of principal payment.
Don’t forget that most HELOCs have a variable rate (some with an option to lock a rate at a cost or addition to the note rate) and are usually tied to the prime rate. So, when the Federal Reserve increases their target rate it raises your HELOC (and other revolving credit accounts) interest rate.
HELOCs seem confusing? Use this simple rule of thumb: for short term borrowing (less than 5 years, perhaps less than that) and an ability to pay more than a minimum payment a HELOC can be a good choice. For long term borrowing (more than 5 years) and a need to have a fixed payment budget, a conventional mortgage is generally a better option.