Imagine having a credit card that allows you to charge large five or even six-figure amounts, and you only have to pay the minimum amount back each month for 10 years.
Sounds like a dream? Well, no, that’s pretty much what an interest-only HELOC is. When you open this home equity line of credit, you specify a specific repayment plan, which means that for the first few years, you only pay interest on the money you borrow, and you don’t have to pay any principal.
However, a HELOC isn’t interest-only forever. While this approach can make borrowing much more affordable at first, it could come as a shock later when you have to start making principal payments. That’s why it’s important to understand what you’re signing up for.
What is an interest-only HELOC and how does it work?
A home equity line of credit (HELOC) is a revolving line of credit secured by the equity in your home (the portion of your property that you own outright, minus your mortgage). You can borrow against this ownership interest to pay for home improvements, pay bills, or even make investments. Because a HELOC is secured (backed) by your home, it usually has a lower interest rate than other forms of financing.
A HELOC has a revolving balance like a credit card, but unlike a credit card, it doesn’t exist indefinitely; instead, it has a set term like a regular loan. An “interest-only HELOC” is basically a term that refers to the first few years of a line of credit. This phase is called the draw period, and you are free to withdraw funds from the line of credit and make interest-only payments instead. Drawback periods are usually 5, 10, or 15 years, with 10 years being the most common.
Once the draw period ends, the HELOC’s repayment period begins, which usually lasts another 10 to 20 years. You can no longer borrow money. Instead, you must pay back the amount you borrowed, just like a mortgage. The minimum monthly payment includes principal and interest, and the payment is 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 defer principal payments until the end of the drawdown period. You only pay interest. To calculate your monthly payment, use this formula:
(Current HELOC balance) x (Annual interest rate charged on the loan) ÷ 12
Let’s say you take out $15,000 from your line of credit and your annual interest rate is 8 percent. Your typical HELOC interest-only payment would be $100 per month ($15,000 x 0.08 ÷ 12).
But all good things come to an end. For example, if you have an interest-only home equity line of credit with a 20-year term and 10 years of drawdown, the loan will self-amortize after 10 years. During the remaining 10-year repayment period, you can’t draw from the line of credit, only make payments.
What is the difference between a traditional HELOC and an interest-only HELOC?
In essence, they are roughly the same today. Interest-only repayments are becoming a standard feature of mortgage-backed lines of credit.
It wasn’t always that way. Originally, HELOC repayments included both principal and interest during the drawdown period, just like mortgages and other loans. Today, there are still “traditional” HELOCs out there that include both principal and interest in your repayments from the start. Lenders may not like the interest-only concept, or they may limit the option to more creditworthy borrowers.
But these loans are becoming less and less common. Most HELOCs are or can be “interest-only” during the drawdown period, meaning the borrower can choose to pay only the interest on the funds they withdraw. This is similar to the minimum monthly payments on a credit card. Of course, you can always pay more, and many personal financial advisors believe you should, to avoid overspending, make your debt more manageable, and avoid the shock of paying back principal and interest when the drawdown period ends.
Pros and Cons of Interest-Only HELOCs
There are advantages and disadvantages to using these lines of credit.
Strong Points
- Low initial payment: Initially, your monthly payments will be lower because you’re only covering interest rather than both principal and interest.
- Flexible borrowing: Withdraw as much as you need during the withdrawal period and repay as much as you need.
- Cost-effective financing: Interest-only HELOC interest rates can be economical compared to credit card interest rates.
- Tax Benefits: You may be able to deduct the interest you earn on funds you withdraw from a HELOC on your tax return.
Cons
- Variable interest rate: Monthly payments may vary based on market interest rates.
- Shorter repayment period: If you choose to make interest-only payments, you effectively shorten your repayment term, so once the drawdown period ends, you’ll need to make significantly higher monthly HELOC payments to pay off the loan on time.
- Price surprise: If you made the interest-only minimum payment during the drawdown period, the new monthly payments during the repayment period can be a big hit to your budget, especially if interest rates start to rise at the same time.
- Total interest paid: Any outstanding balance will result in higher accumulated interest over the life of the loan.
- Risk of seizure: When you take out a HELOC, you must use your home as collateral, and if rising interest rates or increasing bills make the payments unmanageable, you risk losing your home.
When does an interest-only HELOC make sense?
Choosing to make interest-only payments on a HELOC is a good choice if:
- Although there is currently a shortage of income, household income is expected to increase in the future.
- Have accumulated significant housing equity
- Interest rates are likely to decline in the long term
- Plan to move before the drawdown period ends (similar to the strategy for an adjustable-rate mortgage). You’ll still need to make the payment when you sell, but you’ll probably be able to cover the outstanding balance with the proceeds of the sale.
When should you avoid taking out an interest-only HELOC?
An interest-only HELOC may not make sense in some situations and can also be a risky decision if you’re not financially prepared for the repayment structure. Here are some scenarios where an interest-only HELOC may not be a good fit:
Housing property limits
If you don’t have enough equity in your home, this isn’t an option. Any type of HELOC depends primarily on the equity you have in your home. The percentage varies by lender, but most lenders will only let you borrow up to 80 percent or 90 percent of your home’s value.
Low credit score
Remember this lending mantra: The higher your credit score, the lower your interest rate. HELOC lenders reserve their best offers for people with scores of “very good” or above. You might be able to get a home equity line of credit even if your credit isn’t perfect, but your interest rate will be higher, which means you’ll have to pay hundreds, or even thousands, of dollars more over the life of the loan.
Can I open an interest-only HELOC if I have bad credit?
Securing an interest-only HELOC can be tough if you have a low credit score: Many lenders will allow you to tap into your home’s equity with a “reasonable” credit score in the mid-600s, and even a score as low as 620. Some lenders will offer interest-only HELOCs to those with scores below 620, but they may require a larger asset ratio or a lower debt-to-income ratio.
Either way, HELOCs for individuals with bad credit come with higher interest rates, loan size limitations and shorter repayment terms.
Concerns about repayment
Also, avoid an interest-only HELOC if you are not confident that you will be able to make the larger payments when the repayment term arrives or when interest rates (variable rates) rise. Find out how long the drawdown period of the loan is and make a plan for how you will continue to pay off the HELOC as your monthly payments increase. Depending on the terms of the HELOC, this could be years down the road and requires careful financial planning.
What are the alternatives to an interest-only HELOC?
Even if it’s possible, not everyone is comfortable taking out a HELOC, so here are some alternatives.
Mortgage
A home equity loan is similar to a HELOC in that you borrow against the equity in your home. However, instead of getting a line of credit that you can repay as you pay it off, you get a lump sum of money. Your interest rate is fixed, and your monthly payments are fixed as well. Interest rates on home equity loans tend to be a little lower than HELOCs.
Suitable for: They know how much money they need and want it all at once.
Avoid this if: You think you’ll need to tap into your home equity more than once, or you’re not sure how much you’ll ultimately need to spend.
Personal Loans
You can get a personal loan from a bank, credit union, or online lender. Interest rates are determined primarily by your credit score. If you can get a low-interest loan, it’s a good alternative to pawning your home. If the interest rate on a personal loan is much higher than the rate you could get on a HELOC, a personal loan might not be a good option for you.
Suitable for: I have good credit (not much home equity) but I need money fast.
Avoid this if: Your credit has room for improvement or you want a repayment period that spans decades.
Credit card
Credit cards are a quick way to get the funds you need without dipping into the equity in your home. Many cards offer 0 percent interest on purchases or balance transfers for a set period of time, making them a great choice if you have a big expense coming up or need to pay down debt. But be careful: interest rates rise sharply once that introductory period ends, making them a costly option if you can’t pay off your balance right away.
Suitable for: If you need cash quickly, you can earn a 0 percent introductory interest rate if you make a plan to pay it off right away.
Avoid this if: Double-digit interest rates on credit cards can add up quickly and cause debt to mount, so you’ll likely be carrying a balance for a while.
Cash-out refinancing
With a cash-out refinance, you replace your current mortgage with another, larger mortgage and receive the difference in a lump sum. Like a HELOC, the amount of additional cash is based on how much of your home you have. Refinance rates are often comparable to your primary mortgage rate and lower than a home equity loan or HELOC. You may also see a lower monthly payment if you refinance at a lower interest rate than your current mortgage.
Suitable for: You have 20% or more equity in your home, your current mortgage interest rate is higher than today’s average interest rate, and you like the idea of having only one large debt to pay off (versus having multiple mortgages). and Such as a home equity loan (HELOC).
Avoid this if: You took out a mortgage when interest rates were low, so refinancing would result in a significant increase in interest rates. Or, you can’t afford the closing costs of another loan and don’t want to go through the hassle of going through the entire mortgage application process again.
What should I do when my HELOC withdrawal period ends?
Here’s a step-by-step guide on what to do when your HELOC withdrawal period ends.
A few months before the drawdown period on your HELOC ends, review your line of credit balance. Determine what your monthly payments will be and how you need to adjust your budget to account for this.
Once the withdrawal period is over, update your monthly payments to the new amount.
If your new (higher) monthly payments are a financial burden, it’s best to contact your lender rather than just stopping payments. Your lender may offer options, such as extending the amortization term, to reduce your monthly payments.
You could also consider refinancing the HELOC itself.
The Bottom Line on Interest-Only HELOCs
During the initial drawdown period of an interest-only HELOC, your monthly payments will be relatively low because you’re only paying interest. Once the drawdown period of your HELOC ends, you’ll also have to start paying back the principal, which means your monthly payments can increase significantly.
An interest-only HELOC can make borrowing more affordable initially. But keep in mind that the minimum payments won’t last forever. Once the draw period ends, you’ll be responsible for paying back the principal and interest. Before you proceed, make sure your budget can accommodate this type of repayment plan.
