One Loan, Two Payments: How a Home Equity Line of Credit Works

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).