When you take out a home equity line of credit, or HELOC, you pay only the interest for a specified amount of time before you start repaying the principal, too. That’s because a HELOC is an interest-only product during the years of the loan term that the borrower can draw against the line of credit.
Having a HELOC is a bit like having a credit card. You can pay off all or part of your balance and use that money over again. Or, you can choose to just pay off the interest each month. When you make a principal repayment, it will reduce the next month’s interest expense and increase the available credit line.
When the draw period ends, the loan payment amortizes over the remaining loan term. The minimum monthly payment now includes principal and interest, and the payments are large enough to cover the remaining interest expense and pay off the loan by the end of the loan term.
For example, if you have an interest-only HELOC with a 20-year term and a 10-year draw, then after 10 years the loan becomes self-amortizing over the remaining 10-year repayment period, and you can no longer draw against the line of credit.
One option at that point is to take out a new HELOC to refinance the old one. Know, however, that HELOC terms can vary by lender. It is common, though, for a HELOC to have a draw period with interest-only payments.
When should you take out a HELOC?
If you have a good credit score, a good amount of equity in your home and you feel confident that you can make your monthly payments over the duration of the loan, a HELOC can be a good option. HELOC interest rates are much lower than credit card rates, so you’re going in with an advantage.
If you’re looking to upgrade your property to raise its value, your interest-only payments may be tax-deductible. Borrowers must use the HELOC money to “buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the IRS.
What are the alternatives to a HELOC?
Not everyone is comfortable taking out a HELOC. After all, failure to make the payments can result in a foreclosure on your house. Here are some alternatives.
You can always wipe out your current mortgage with an entirely new mortgage. Your new mortgage is higher than your current mortgage, and the difference is the amount you get in cash.
A home equity loan is similar to a HELOC in that you are borrowing against the equity in your house. But instead of getting a line of credit that you can draw against and reuse as you repay it, you get a lump sum. Your rate is fixed and so are your monthly payments. Rates on home equity loans tend to be a little lower than they are for HELOCs.
You can always take out a personal loan from your bank, a credit union or an online lender. Your credit score largely determines what your interest rate will be. If you can snap up a loan with a low interest rate, it can be a good alternative to borrowing against your house.
When you take out a HELOC, you’ll pay only the interest during your draw period. After that, you’re locked out of the line of credit and you must continue to make principal and interest payments until the loan is paid off in full. As with any loan, there are pros and cons, so consider it carefully before making a decision.
Do you have a question about personal finance? Bankrate’s team of experts will gather and select questions to be answered online in the Bankrate Mailbag. Please email your question to BankrateMailbag@bankrate.com.