In my last post about home equity lines of credit (HELOC’s) for physician families, I told you the one thing your family must know about your HELOC. Today, I’ll explain how they work, and give you some idea of what they cost.

HELOC’s typically have two payment periods, and the monthly payment for each period is figured differently.

1. The Draw Period: Flexible, friendly payments

When you originate or “get” a HELOC, the “draw period” begins. During this 10 or 15-year period, you can “draw” money off the line, meaning you use your home equity line of credit like a credit card. When you borrow against the line to buy a car, make a home repair, or pay a surprise tax bill, your lender will begin to calculate your interest.

During the draw period, your minimum payment is typically “interest-only” so the payments may be very small relative to the amount you borrowed. For example, if you borrowed $120,000 and the rate on your HELOC is 5%, you might have a monthly interest-only payment of $500 (that’s $120,000 times 5% divided by 12 months).

The one thing you need to know about the draw period is that the payment may change from month to month, even if your balance stays the same. That’s because the interest rate on HELOC’s is almost always variable.

2. The Repayment Period: Bigger payments, locked in

At the end of the draw period, the “repayment period” begins. At this point, the “line” is converted into a conventional “loan” with amortizing payments based on a 5, 10 or 20 year period.

If you’re a physician and the word “amortizing” is a mystery to you, look at its Latin root: mort meaning death. An amortizing monthly payment contains interest due for that month, plus it contains repayment of principal, and that principle gradually “kills” your debt by reducing the balance every month, putting your debt to death (nice!).

The one thing you need to know about the repayment period is that the payments are MUCH bigger than the minimum payments you’ll make during the draw period.

Back to our example, if you owe $120,000 when the repayment period begins, and your rate is 5%, if you’re loan amortizes over a 10 year period  you will have a $1,273 payment the first month (of which $500 is interest, and $773 is principal). Note that this payment is more than double the payment from the draw period.

If you didn’t know about this huge increase in payment, you might have be surprised, or even encounter some difficulty (and it’s exactly this payment change phenomenon that’s triggered some of the problems in the housing market today).

In my last post about building your dream home, I painted a gloom and doom picture of total financial annihilation for unwary doctors who stumble into an adjustable rate mortgage, thus beginning what I called The ARMs Race.

Today I’ll tell you how to win The ARMs Race. And the secret is…

Don’t get an adjustable rate mortgage in the first place!

Really, there are other perfectly good ways to finance the construction of your dream home, and one of my favorites is what the mortgage know-it-alls call a “one close.”

How the One Close Loan works…
There are two phases of owning your dream home: building it, and living in it.

While you’re building it, you need a construction “loan.” I put “loan” in quotes because it’s not really a loan in the truest sense of the word. It’s actually a line of credit where the bank reimburses the builder on an as-needed (called “percent completion”) basis. This way, you only pay interest on the part of the construction loan you’ve actually used.

While you’re living in your dream home, you need “permanent” financing; what most people think of when they hear the word “mortgage.”

It would be cool if you could get just one loan to cover both phases of owning your dream home, but you can’t. Why? Because nobody (including your builder) knows exactly what your finished home will cost.

But you can apply for and close on the construction and permanent loans at the same time in what they call a “construction-to-permanent loan.”

… and why it’s so great…
A one close loan lets you lock both the interest rate on the construction loan AND the interest rate on the permanent loan at the same time. This means you’ll know EXACTLY what rate you’ll get when you’re home’s finished (as many as 15 months into the future), AND if home mortgage rates rise dramatically while you’re building your dream home, you won’t have to worry that your payments will grow larger than your budget.

So, now that you know what you want, you can march into your mortgage broker’s office, slap the hardwood top of his paper-strewn desk , and shout confidently, “I want a one close construction loan with permanent financing in a 30-year fixed product, I want a 15-month* lock, and I want it NOW.”

…but why you’ve never heard about it.
With a sly smirk on his face, your mortgage broker will stare thoughtfully out the window for a moment and then turn to you with a sigh to say, “I can do that, but it’s going to cost you.”

He knows that the 15-month lock is going to add up to one full percentage point to the cost of your loan (about $10,000 on a one million dollar mortgage), and he’s not sure how you’re going to feel about it. As I said in my last post, up-front fees like these usually cause casual rate shoppers to move on to cheaper pastures, and that’s why this one close loan with a long lock date may be news to you.

You see, you can have certainty in the rate you’ll pay on your mortgage for 30 years after the home’s finished, and you can lock in that rate 15 months before construction begins, but somebody has to bear the risk that rates will rise after the loan is locked, but before the permanent loan is funded.

After all, mortgage interest rates are a market-driven commodity, and there’s risk involved for the lender.

When you pay a fee up front to lock in the rate, it’s like buying rate insurance, if you will. When you pay that fee, you’re compensating the lender for the risk they’re bearing.

Is this One Close financing right for your family?
The answer here is “yes” if…

• The estimated price tag is near the high end of your budget
• You’re believe things will come in on-time and on-budget,
• You don’t mind paying a premium when it comes to your financial security, and
• You don’t like to gamble when it comes to owning your dream home.

After all is said and done, you’ll feel good knowing you’ve provided your family with a high quality home, and you’ll feel even better knowing you can still afford that home for years to come… even if it costs a little more today.

* Here, I used a 15-month lock in my example. What you really want is a lock that’s about 3 months longer than your builder’s estimate for the time it takes to finish your house, just in case he’s slow in finishing the job.

In the past several weeks I’ve helped more than my fair share of physician families navigate the waters of utlra-jumbo construction loans amid the crisis surrounding the subprime implosion. I’ve decided to coin a term here and call this phenomenon The ARMs Race.

The ARMs Race begins when you, the head of your family, decide it’s time you built your dream home. Whether it’s a castle on the hill or a cottage on the sand, one thing’s for certain: when it’s all said and done, the price tag will be more than a million dollars.

So you make a trip to the banker, and that’s where the trouble begins.

You want the lowest rate, naturally, and you want the lowest cost to originate the loan. The banker, to keep you from shopping elsewhere, naturally obliges with a low cost loan, and often it’s a “5 and 1 ARM” or adjustable rate mortgage.

“An ARM?”, you say with alarm. And with a consoling look the banker says confidently, “Why yes, an ARM. Look, it’s inexpensive, and once your house is finished, you can refinance into a long term, fixed rate mortgage.” You know, the kind of mortgage your mother told you to get.

So you get the ARM… because it’s cheap, low cost, and it kept you from shopping elsewhere. And The ARMs Race begins.

If life happens according to the banker’s prognostication, all is well. You get your ARM, you build your house, you refinance after it’s all done, and walk away happy. The ARMs Race ends well.

BUT only IF things go according to the predictions.

When the rates begin to rise, as they did recently, then you may well be stuck with the ARM for as long as two years (because many have a prepayment penalty), or longer if you forget about it and wake up five years later when the first interest rate reset happens, in which case you get a huge increase in your monthly payment.

The ARMs Race intensifies as you realize (about a year or two after you get the loan) that rates have risen, and now if you want to refinance into a fixed rate loan, your rate will be even higher than it was when you got the ARM in the first place. When you add a 1% origination fee to the new loan (about $10 grand), the pain is intense.

And finally, if you continue with your ARM during a time when rates have risen dramatically, you may find yourself in The Day After. Here, you can no longer afford your mortgage, and you decide to sell your house.

But you find yourself in an interesting situation. You own a house that you – a doctor – cannot afford, trying to sell a seven figure home in an environment where most people cannot get a loan. Which means you may need to cut the price. But you probably lad little or no equity in the house to begin with, so you might actually be forced to write a check to get rid of it. Ugh.

So what can you do? Stay tuned. I’ll bail you out in my next post.