What is an interest-only HELOC and how does it work?

An interest-only HELOC lets you borrow against your home’s equity while paying just the interest for a set time, keeping initial payments low. But once that period ends, typically after five to 15 years, your costs can rise sharply as you begin repaying the principal.

These loans can offer flexibility for borrowers managing short-term expenses or uneven income, but they also carry the risk of payment shock and growing debt if not handled carefully. Understanding how interest-only HELOCs calculate payments, shift into repayment and affect overall borrowing costs is essential to deciding whether this option fits your financial goals.

What is an interest-only HELOC?

A home equity line of credit (HELOC) has a revolving balance, like a credit card. But unlike a credit card, it doesn’t exist indefinitely — it has a set term, like a regular loan. “Interest-only HELOC” refers to the line of credit available to borrowers during the first several years of borrowing. During this phase, called the draw period, you’re free to draw funds from the line of credit and make interest-only payments. The draw period is normally five, 10 or 15 years, with 10 being the most common.

When the draw period ends, the HELOC repayment period begins and typically lasts 10 to 20 years. You can no longer borrow money; instead, you must repay the outstanding balance, as you would on a mortgage. The minimum monthly payment now includes both 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.

How does an interest-only HELOC work?

With an interest-only HELOC, you’ll push off making payments on your principal until after your draw period expires. All you’ll be paying is the interest. To calculate your monthly payment, use this formula:

Let’s say you’ve drawn $15,000 against your credit line, and your annualized interest rate is 8 percent. Your regular HELOC interest-only payment would be $100 a month ($15,000 x .08 ÷ 12).

But after the 10-year draw period, you can no longer withdraw funds, and the balance becomes self-amortizing. Over the remaining 10-year repayment period, you’ll repay the principal balance plus interest.

Interest-only HELOC vs. traditional HELOC: What’s the difference?

Essentially, they are pretty much the same now. Interest-only is becoming a standard feature of home equity lines of credit.

It wasn’t always so. Originally, HELOC repayments during the draw period included both principal and interest, as with mortgages and other loans. While “traditional” HELOCs still exist, with payments that cover both principal and interest from the start, they’re less common.

Most HELOCs are, or can be, “interest-only” during the draw period. They give the borrower the option to make a payment that covers only the interest on the withdrawn funds — not unlike the minimum monthly payment on a credit card. Of course, you can always pay more, and many personal finance advisors think you should to avoid overspending, keep debt manageable and avoid the sticker shock of combined principal and interest repayments when the draw period ends.

Pros and cons of an interest-only HELOC

There are benefits and drawbacks to using these lines of credit.

Pros

• Smaller payments: Initially, your monthly payments are lower because you’re only covering interest, not both principal and interest.
• Flexible borrowing: You take out as much or as little as needed during your draw period. And repay as much or as little as you want.
• Cost-effective financing: HELOC interest rates are generally much lower than credit card rates.
• Tax benefits: You may be able to deduct the interest made on your withdrawn HELOC funds on your tax return.

Cons

• Variable rates: Your monthly payment can fluctuate based on market interest rates.
• Shorter repayment window: Opting for interest-only payments essentially shortens your repayment period. That’s why, once the draw period ends, your monthly HELOC payments must escalate significantly to settle the loan on time.
• Sticker shock: If you’ve just paid the interest-only minimums during the draw period, the new monthlies during the repayment period can be a big blow to the budget — especially if interest rates simultaneously start to rise.
• More total interest paid: Maintaining an unpaid balance leads to higher accumulated interest throughout the loan’s duration.
• Foreclosure risk: With any HELOC, you’re putting your home on the line. If your payments become too much to handle, whether due to rising rates or bigger bills, you could be in danger of losing your home.

When does an interest-only HELOC make sense?

Since the cons are considerable, it’s important to consider whether the interest-only route works for you. As with any HELOC, it may be a good idea if you have excellent credit (a FICO score of 700-plus) and a considerable amount of home equity. The bigger your ownership stake, the more you can borrow, and your creditworthiness determines the interest rate you can secure.

More specifically, an interest-only HELOC makes sense if you:

• Are cash-strapped now, but expect to increase your household income in the future, allowing you to comfortably afford bigger payments later on.
• Think interest rates are trending down long-term. Lower rates could mitigate the bite when you have to start repaying both principal and interest, but it’s not wise to put too much stock in what the future market might do.
• Plan to move before the HELOC draw period ends. Akin to what some borrowers do with an adjustable-rate mortgage, this strategy lets you avoid making monthly principal and interest payments at all. You’ll have to settle up when you sell, but presumably your sale proceeds will cover the balance due on the HELOC.

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

An interest-only HELOC won’t make sense in some situations and could even be a risky decision if you aren’t 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, a HELOC may not be an option for you. Qualifying for any type of HELOC is primarily dependent on your home’s equity. Percentages vary by lender, but most require a minimum equity stake of 15 to 20 percent. Also, they will only let you borrow up to 80 or 90 percent of your home’s value.

Low credit score

Remember this financing mantra: The higher your credit score, the lower your interest rate. HELOC lenders save their best offers for those with scores in the “very good” and up range. You may still be able to get a home equity line of credit with less-than-perfect credit, but interest rates will be higher. This means that you’ll have to pay hundreds, if not thousands of dollars more, throughout the loan term.

In any event, HELOCs for individuals with poor credit would entail higher interest rates, restricted loan amounts and abbreviated repayment terms.

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.

What are alternatives to an interest-only HELOC?

Not everyone is comfortable taking out a HELOC, even if they can afford it. 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 reuse as you repay it, you receive a lump sum. Your rate is fixed, and so are your monthly payments. Rates on home equity loans tend to be slightly lower than those for HELOCs.

Good for: You know how much money you need, and you’d like to get it all at once.

Avoid if: You think you’ll need to tap into your home equity multiple times, and/or aren’t sure of how much you’ll ultimately need to spend.

Personal loan

You can borrow a personal loan from your bank, credit union or an online lender. Your credit score largely determines your interest rate. If you can get a low-interest loan, it can be a good alternative to putting your house on the line. 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.

Good for: You have good credit (but not much home equity) and need funds quickly.

Avoid if: Your credit could use improvement, or you’d like a decades-long repayment term.

Credit cards

Credit cards can be a fast way to get the funds you need without dipping into your home’s equity. Many cards have 0 percent interest on purchases or balance transfers for a set period, which is convenient if you have a big expense coming up or need to pay off some debt. But be careful — once the intro period ends, the interest rates can jump to 20 percent or higher, making it a pricey option if you can’t pay off the balance quickly.

Good for: When you need quick access to cash, plan to pay it off soon and can snag a 0 percent introductory rate.

Avoid if: You think you might carry a balance for a while, as credit cards’ double-digit interest rates can add up fast, making your debt mushroom.

Cash-out refinance

A cash-out refinance replaces your current mortgage with another, larger one, and you receive the difference in a lump sum. As with HELOCs, the amount of extra cash you can borrow is based on your equity stake in your home. Refinancing rates are often comparable to primary mortgage rates, and lower than those of home equity loans and HELOCs. And if you’re refinancing at a lower interest rate than on your current mortgage, your monthly payments may even drop.

Good for: You have at least 20 percent equity in your home, and your current mortgage rate is higher than today’s average rates. Also, you like the idea of having a single large debt to repay (vs. having a mortgage and a home equity loan or HELOC).

Avoid if: You got your mortgage when rates were low, and refinancing would result in a substantially higher rate. Or you can’t afford closing costs on another loan/don’t want the hassle of going through the whole mortgage application process again.

Bottom line

During the initial term of an interest-only HELOC, your monthly payments are relatively low because you’re only paying interest. But once the draw period ends, you’ll be required to start paying down the principal. This means your monthly payments will increase, possibly significantly.

An interest-only HELOC can make borrowing more affordable. But remember, you’re living on borrowed time with those lower payments. When they increase, as they inevitably will, it could mean sticker shock. So, be sure your budget will be ready — even before you sign those HELOC agreement papers.

Frequently asked questions

• Can you make principal payments on an interest-only HELOC?

  Yes, you can make principal payments on an interest-only HELOC. While an interest-only HELOC typically lets you delay those until the repayment period, most lenders allow you to repay the principal (the amount you actually borrowed) whenever you want. If you do pay down the principal early, you’ll also reduce the overall interest you’ll pay. You’ll also replenish the credit line, allowing you to withdraw those funds again.

• How long do you make interest-only payments on a HELOC?

  You’ll typically make interest-only payments on a HELOC during the draw period, which usually lasts 5 to 15 years. This is the time when you can borrow against the line of credit and only pay interest on what you’ve used. Once the draw period ends, you’ll enter the repayment phase, where you’ll start paying both principal and interest.

• What should I do when my HELOC draw period ends?

  As your draw period is ending, review your balance and calculate your new monthly payment. If the larger amount is an issue, be sure and contact your lender to explore options like extending the repayment term. You could also consider refinancing the HELOC.

Additional reporting by Larissa Runkle and Erik J. Martin