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If you have a HELOC, it’s most likely tied to Prime Rate. This means when Prime Rate is low, you benefit from a lower cost of borrowing and lower payments. However, when Prime Rate starts to increase, your cost of borrowing and payments will get higher as a result. And that looks to be happening this year in 2022.
For the first time in a long time, it looks like HELOC rates could be on the rise. The Bank of Canada is set to increase interest rates for the first time since prior to the Coronavirus worldwide pandemic.
Most economists have predicted at least four 0.25% increases in 2022, possibly more. This is mostly due to rising inflation. Canada is currently seeing the highest inflation in 30 years. The Bank of Canada’s hope is that by increasing interest rates, it can slow the rate of inflation to a more manageable pace.
If you’re a borrower with a HELOC, that means that higher rates and payment could be just around the corner.
There’s a misconception out there about interest rates that I wanted to clear up. Double the interest rate doesn’t always mean that your payment will double, for example if you have a variable rate mortgage. However, for HELOCs it’s different. To help illustrate this, I’ll go through a hypothetical HELOC example.
Let’s say you have a HELOC with a $200,000 outstanding balance. You borrowed from it to do some much-needed home renovations over the last couple of years.
If your HELOC rate is currently 2.95% (2.45% Prime Rate + 0.50%), then your minimum interest-only payment would be $490 per month. However, if your interest rate doubled to 6%, your minimum interest-only payment would be $1,000 per month. That’s over double the amount. If this were a variable rate mortgage, the payment would be nowhere near double if interest rates doubled. It would only be about a third higher. That’s because HELOC payments are calculated differently. HELOCs allow interest-only payments, while variable rate mortgages require mortgage payments that include both interest and principal.
As you can see, double the interest rate equal double the payment when it comes to HELOCs.
With that out of the way, let’s look at some ways to protect your HELOC from rising rates in 2022.
If you’re concerned about higher HELOC rates, you have the option of locking in your rate. At any point, you should be able to lock some or all of your HELOC balance into a fixed rate mortgage. This can make sense depending on where fixed rates are at the time and what your long term plans are.
For example, if your HELOC rate is currently 2.95% and fixed mortgage rates are at 3.25%, for an extra 0.30%, you could have the safety and security of knowing exactly what your payments will be.
However, a downside to this is the mortgage penalties. If you might have to break your mortgage at some point during the term, paying a penalty can negate any of the interest savings you might have had. And fixed rate mortgages tend to come with a lot higher penalties. Basically, you’re paying a premium to have your rate guaranteed up front and a premium on the backend to break it early, so be careful.
If you’re not quite ready to lock in your rate, you could pay your HELOC as if rates are already higher.
For example, in the earlier example, if your minimum interest-only payment is $490, anything that you pay above that will go towards principal. So if you pay $690 a month, $490 of that will go towards servicing the interest, while $200 will go towards paying down the principal. That means instead of a balance of $200,000, your balance would only be $199,800. And your payments would be slightly lower as a result because you’re paying down the principal.
Another option is to switch to a variable rate mortgage. If your main objective is to save on interest, switching your HELOC balance to a variable rate mortgage can do that. Variable rate mortgages are about 1.50% lower than HELOC rates at that time of this article.
Variable rate mortgages are priced in a way that you’ll almost always savings interest. While HELOCs are almost always priced at Prime plus something, variable rate mortgages are almost always priced at Prime minus something.
For example, your HELOC might be Prime + 0.50%, while your variable rate mortgage is Prime – 1.00%. No matter what Prime Rate is, your variable rate mortgage interest rate will always be lower.
That being said, if paying the lowest payment possible is your main objective, it probably makes the most sense to stick with a HELOC, as your payments will be higher if you go with a variable rate mortgage. That’s because you’re required to make principal and interest payments.
If you went with a variable rate mortgage at a rate of 1.45%, your monthly payment would be $795 based on a balance of $200,000. That’s $305 more than you’d be currently paying with your HELOC.
We went over the way to protect yourself from rising HELOC rates. Now it’s all about choosing a way and putting it into action.
