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HELOCs aren’t interest-only forever

HELOC is not interest only forever
Iriana Shiyan/Adobe Stock
HELOC is not interest only forever
Iriana Shiyan/Adobe Stock
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A home equity line of credit, or HELOC, is a revolving line of credit secured by the equity in your home. If you have extra equity in your home, you can borrow against that to fund home improvements or any other investments that you like.

Because HELOCs are secured by your home, they typically offer lower interest rates than other forms of borrowing. You can also apply for an interest-only repayment plan when opening a HELOC, which means that for the first several years you only have to pay interest on the money borrowed and not the principal.

This repayment approach can make borrowing even more affordable initially, but lenders typically have special requirements to qualify for an interest-only HELOC and it’s important to understand what you’re signing on for.

What is an interest-only HELOC?

An interest-only HELOC is a home equity line of credit with a repayment structure that requires only paying the accrued interest on the money you’ve borrowed during the initial period of the loan.   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.

The interest-only period doesn’t last forever though. 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 does an interest-only HELOC make sense?

An interest-only HELOC won’t make sense in some situations and could even be a risky decision if you are not financially prepared for the repayment structure. Here are some of the scenarios in which an interest-only HELOC may not be right for you.

Limited home equity

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.

Low credit score

Another reason to avoid an interest-only HELOC is if your credit score is low. You may still be able to get a home equity line of credit with less than perfect credit, but the interest rates will be higher. This means that you’ll have to pay hundreds if not thousands of dollars more over the course of the loan.

Repayment concerns

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.

When should you avoid taking out an interest-only HELOC?

An interest-only HELOC won’t make sense in some situations. 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.

Another reason to avoid an interest-only HELOC is if your credit score is low. You may still be able to get a home equity line of credit with less than perfect credit, but the interest rates will be higher. This means that you’ll have to pay hundreds if not thousands of dollars more over the course of the loan.

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.

Home equity loan

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.

Personal loan

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 get a loan with a low interest rate, it can be a good alternative to borrowing against your house because it doesn’t come with the risk of foreclosure. If the interest rate on your personal loan is much higher than the rate you could get with a HELOC, a personal loan might not be a great option.

Mortgage refinance

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. A mortgage refinance usually won’t get you any money upfront but can give you more money each month.

Cash-out refinance loan

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. This can be a good option if you’re looking to get a lump sum of cash upfront. And if you’re refinancing with a lower interest rate, your monthly payments may not even go up.

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:

  1. 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.
  2. 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.
  3. Once your draw period ends, update your monthly payment to the new amount.
  4. 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.
  5. 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

As a home equity line of credit that only requires paying interest during the draw period, an interest-only HELOC can make borrowing more affordable initially. But remember, those minimal payments don’t last forever. When the draw period ends, you will be responsible for repaying principal and interest. Before proceeding, be sure your budget can accommodate this type of repayment plan.

Written by
Libby Wells
Contributing writer
Libby Wells covers banking and deposit products. She has more than 30 years’ experience as a writer and editor for newspapers, magazines and online publications.
Edited by
Loans Editor, Former Insurance Editor
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Part of  Home Equity Line of Credit (HELOC) Basics