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.
What is an interest-only HELOC?
With an interest-only HELOC, your initial monthly payments only include the accrued interest on the money that you’ve borrowed. This interest-only period is called the draw period — you’re free to take funds from the line of credit and simply make interest-only payments in return.
But the interest-only period doesn’t last forever. When the draw period ends, the loan payment amortizes over the remaining loan term. The minimum monthly payment then includes principal and interest, and the payments are large enough to cover the remaining interest and pay off the loan by the end of the loan term.
For example, if you have an interest-only home equity line of credit with a 20-year term and a 10-year draw, then the loan becomes self-amortizing after 10 years. Over the remaining 10-year repayment period, you can no longer draw against the line of credit.
When should you take out an interest-only HELOC?
If you have a good credit score and at least 15-20 percent equity in your home and you feel confident that you can afford repayment when the draw period ends, an interest-only HELOC could be a good option. An interest-only HELOC could make sense in a few scenarios:
If you’re looking for a source of money with flexible payments, then an interest-only HELOC might be a good choice. Because the introductory draw period only requires you to make payments on the interest that accrues, your monthly payments are lower in the beginning of the loan term.
If you want to pay additional money toward the principal, you can do that at any time.
Lower interest rates
HELOC interest rates are typically much lower than credit card rates, so you’re going in with an advantage. If you have upcoming expenses where you need a certain amount of money, a HELOC will be cheaper than a personal loan or credit cards.
That benefit comes with a risk, however: HELOCs are secured by your home. That means if you default on your home equity line of credit, you’re at risk of foreclosure and losing your home.
If you want to upgrade your property to raise its value, your interest-only payments may be tax-deductible. Borrowers must use their HELOC money to “buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the IRS.
Refinancing another loan
A HELOC can be an attractive option if you’re looking to consolidate another loan or loans with higher interest rates. You can also 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 avoid taking out an interest-only HELOC?
There are a few situations in which an interest-only HELOC won’t make sense. If you don’t have a lot of equity in your home, it won’t be an option for you. Any type of HELOC is primarily dependent on your home’s equity. Percentages vary by lender, but most will only let you borrow up to 80 or 90 percent of your home’s value.
You should also avoid an interest-only HELOC if you aren’t confident you can make larger payments once the repayment period arrives or if the interest rate — which is variable — rises. Know how long your loan’s draw period is and make plans for how you’ll continue paying off the HELOC once your monthly payment increases. This might be several years down the line, depending on the terms of your HELOC, and requires careful financial planning.
What are alternatives to an interest-only 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:
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 take out a personal loan from your bank or 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, since it doesn’t come with the risk of foreclosure.
Refinancing your mortgage replaces it with one that carries a better rate or payment terms. Your monthly payments will even go down if you’re able to secure a lower interest rate. Just keep in mind that you’ll be extending the number of years you have to pay a mortgage.
You can wipe out your current mortgage with an entirely new one. Your new mortgage will be higher than the balance on your current mortgage, and you’ll receive the difference in cash.
What should I do when my HELOC draw period ends?
During the initial draw period of an interest-only HELOC, your monthly payments are relatively low because you’re only paying interest. Once your HELOC draw period ends, you’ll be required to start paying down the principal as well. This means that your monthly payments will go up, possibly significantly. Here’s a step-by-step guide for what to do when your HELOC draw period ends:
- Before your draw period ends, be vigilant about how much money you withdraw from your HELOC. Since there is no set loan amount, it can be easy to withdraw more than you’re expecting. Being attentive to the amount you borrow will help keep your principal (and therefore your monthly payments) lower.
- A few months before your HELOC draw period ends, look at the balance on your line of credit. Determine about how much your monthly payments will be and how you’ll need to adjust your budget to account for that.
- Once your draw period ends, update your monthly payment to the new amount.
- If the new (higher) monthly payment is a financial burden, it’s better to reach out to your lender than to stop making payments. Your lender may offer options like increasing the amortization length, which will lower the monthly payment.
- Besides talking with your lender, you have a few other options if the higher monthly payment is a burden. You could consider refinancing your mortgage, getting a personal loan or getting cash out from your home equity.
The bottom line
When you take out an interest-only 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.