HELOCs Vs Conventional Mortgage Interest

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.

Interest tableThe 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.

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A Housing Bubble?

A real estate bubble is generally defined by over speculation in the housing market. That bubble leads to unsustainable price levels that are generally not affordable by the average home buyer. When prices surge beyond the affordability level it is an indication that home prices are too high.Bubble

Many factors drive affordability. Interest rates, being a primary factor, have a direct implication on affordability. A bubble could be created simply by interest rates increasing which has direct impact on decreased affordability. For example, a $300,000 home financed with an interest rate of 3% may have a total payment [PITI] of $1,725. At 6% the total payment might now be $2,240.

Certainly in the Twin Cities and around the entire Midwest home prices have risen significantly from 2017 to 2022. Coupling that with higher interest rates currently, many could speculate that we are in a bubble. However, in order to properly analyze that we have to look at affordability. If home buyers can still afford to purchase a $300,000 home at 8% rates, then home prices have more room to grow.

The Affordability Index

Per the most recent Minneapolis area Association of Realtors report [http://maar.stats.10kresearch.com/] their affordability index is 102. This is a significant decrease from a year ago (almost 30%). The decrease was driven by a combination of another year of significant home price gains and a doubling of average market interest rates. An index rating of 100 means at current interest rates the average priced home is perfectly affordable for the average income family. By our definition then we are not in a housing bubble quite yet. However, with months of supply still hovering around one month, buyers may be willing to stretch their budget and pay more than what they normally would for a new home. This could be construed as over speculation. We have a different theory.

Old house

What we expect to see happen is home sales slowing down now due to higher interest rates and lower affordability. Buyers will be more reluctant to stretch their budgets further in order to own a home. Unfortunately, home ownership will be out of reach now for many would-have-been home owners. We do not think this will cause a decrease in home prices, rather a stabilization in prices and an end to the 10% levels of year-over-year appreciation gain.

This all changes, of course, if interest rates continue to increase in to the 7-8% range or higher. No one knows what interest rates will do for sure. There are simply too many factors that determine market rates and knowing how all of

them will interact with each other in this new environment is impossible.

How is this different from 2005? 

Nearly everyone who has purchased a home since 2010 has earned it. Mortgage underwriting guidelines have actually been adhered to over the past 12 years. Up to 2006, the mortgage industry could finance nearly everyone, regardless of income, credit, or an ability to repay the loan. The last bubble was caused by over speculation, coupled with a lack of foundation in the financing instruments that fueled that speculation. Today is different – mortgages are on a solid foundation and at time of origination, the borrowers actually had to demonstrate an ability to repay their loan.

The best advice we can give to our clients is if an opportunity exists to own a home within your budget, then take advantage of the opportunity.

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Offer Strategies to Buy A Home

First, we should tell you that without an expert Realtor and Loan Officer, your chances of getting an offer accepted today are lower. The number one reason to hire the Furlong Team at SWBC Mortgage is our reputation to deliver. Realtors know we close on time, financing issues are non-existent, and they generally like us.

We recommend some/all of the following tactics for your next offer:

  1. Closing date: always use “On or before” and let the seller determine closing date
  2. Closing timeframe: 30 days or less is possible if required for us to get the house
  3. Written statement: due within 3 weeks of offer acceptance or at least a week prior to closing
  4. Increase earnest money to down payment amount or significantly higher than $1,000/$2,000
  5. Have you considered non-refundable earnest money?
  6. Increase down payment to at least 10% or more if client qualifies with a higher amount
  7. Please send me listing agent’s contact information when the offer is submitted
  8. Send me a copy of the offer
  9. Asterisk clause on appraised value – discuss options with me
  10. Escalation clause on purchase price?
  11. Leave your offer on the table as back up offer if not selected
  12. Rent back option to seller
  13. Close within 18 days- we need to have an underwriting approval first! See our Certified Home Buyer program details here: https://furlongteam.com/mortgage-approval-types/
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Unfreezing Your Credit Report

Frozen credit should be “unfrozen” before you submit a loan application. This can be done easily online:

Experian: https://www.experian.com/freeze/center.html

Equifax: https://www.equifax.com/personal/credit-report-services/credit-freeze/

Transunion: https://www.transunion.com/credit-freeze

 

or by calling the three credit repositories here:

Experian: 888-397-3742

Equifax: 888-298-0045

Transunion: 888-909-8872

 

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