**What is the Effect on a HELOC of an Interest Rate Adjustment during the Repayment Period?**

**Issue/Inquiry**

The Bank has HELOCs in repayment with the rate of interest tied to the Wall Street Journal Prime Rate. These HELOCs have been set up with amortization schedules, which are adjusted annually on the anniversary of the conversion. With the recent change in the prime rate, should the rate of interest for the HELOCs be changed or should that wait until the anniversary date?

**Response Summary**

A change in the index will be given effect according to the terms of the HELOC. If the initial agreement provided for a rate of interest floating at the Wall Street Journal Prime Rate but fixed payments of principal and interest during the repayment period, which are adjusted annually, the rate of interest would change as the prime rate changes, but the monthly payments would only change on the date of adjustment.

**Response Detail**

Under Regulation Z, if a home equity plan provides, in the initial agreement, for a period during which no further draws may be taken and repayment of the amount borrowed must be made, then all disclosures concerning the repayment period should also have been made, including the length of the repayment period and how the minimum periodic payment is determined. If the Bank used an index—in this case, the Wall Street Journal Prime Rate—to determine the rate that will apply at the time of conversion to the repayment phase, that information should have been provided as well. 12 CFR §1026.40(d)(5); Official Comment, §1026.40 – 4, 40(d)(5)(ii) – 1.

The plan provides for interest floating at the Wall Street Journal Prime Rate and for monthly payments of principal and interest during the repayment period, in an amount sufficient to amortize the loan over the term of the repayment period at the rate of interest in effect when the determination was made. The amount of the monthly payment will be adjusted annually based on the prime rate in effect on the date of adjustment. The terms of the plan will govern how interest accrues and how the amount of the monthly payment is determined. In this case, the rate of interest will change as the prime rate changes, but the amount of the monthly payment will change only on the date of adjustment.

What would be the result of an interest rate adjustment? If the prime rate decreased, less interest would accrue and the fixed monthly payment, which is based on amortization at a higher rate of interest, would pay the outstanding balance off more quickly, since more of it would be applied to principal after the accrued interest was paid. If the prime rate increased, on the other hand, more interest would accrue and more of the fixed monthly payment would be used to pay such interest, with correspondingly less available to pay the outstanding principal. As a result, the principal balance would be paid off less quickly than anticipated when the monthly payment was determined. Depending on the size of the increase in the prime rate and the way in which the monthly payment was determined, there may be a possibility of negative amortization. In that case, Regulation Z would have required the Bank to disclose in the initial disclosures that negative amortization will or may occur. 12 CFR §1026.40(d)(9).

When the annual adjustment is made again, a new monthly payment would be calculated based on the prime rate in effect, the outstanding principal balance, and the remaining term of repayment. This monthly payment would be sufficient to amortize the outstanding principal balance over the remaining term of the loan, but any changes in the prime rate would have the effect described in our example.

The actual terms of the Bank’s HELOCs must be reviewed, however, in order to determine the effect of a prime rate change.