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 loan term is divided into two parts: a draw period and a repayment period. During the draw period, you’re free to take funds from the HELOC and simply make HELOC interest-only payments in return. 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 home equity line of credit 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, 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, a good amount of equity in your home and you feel confident that you can afford repayment when the draw period ends, an interest-only 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.
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, this will not be an option for you as you won’t have anything to borrow against. Any type of HELOC is primarily dependent on your home’s equity.
You should also avoid an interest-only HELOC if you aren’t confident you can begin making payments once the repayment period arrives. 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.
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, 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.
Refinancing your mortgage allows you to avoid a new loan entirely, instead replacing your existing mortgage with one that carries a better rate or payment terms. If your new loan amount is larger than what you owe on your existing mortgage, you’ll get to keep the difference in cash – which can be used in place of funding from an interest-only home equity line of credit. Your monthly payments will even go down if you’re able to secure a better interest rate. Just keep in mind that you’ll be extending the number of years you have to pay a mortgage.
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.