An interest-only HELOC is a line of credit that allows borrowers to make only interest payments during a specified draw period, typically lasting five to 15 years, with 10 years being the most common.
As a homeowner, you may have valuable capital tied up in your home. An Interest-Only HELOC can give you access to some of the value of your home, freeing up options for you. You withdraw funds as you need them and pay interest on the balance.
This option may give you the financial flexibility you seek, but you also need to weigh the risks and benefits. Other loan choices may be preferable, so find out the long-term implications before taking the plunge.
Understanding Interest-Only HELOCs
A HELOC works like a credit card based on your home equity, where you can withdraw money as you need it. With an interest-only HELOC, you don’t have to pay back the loan amount during the draw period when you take out funds.
Home equity is the difference between your home’s market value and the amount you owe on the property. With a HELOC, you can borrow money up to 80% of your home equity. Interest rates are usually lower than a credit card because the home is the collateral.
An interest-only HELOC allows you to borrow money, paying interest only on the loan. You’ll pay off the principal after an agreed period, usually 10 to 15 years later. When the draw period ends, you pay back the principal, and you may no longer withdraw funds.
How Does an Interest-Only HELOC Work?
An interest-only HELOC is a line of credit. You only pay interest on the balance, so if you delay withdrawals or draw down fewer funds, it will cost less. You don’t have to pay back the principal until the draw period ends.
Your monthly payment is based on the amount you owe and your negotiated interest rate. Interest rates are variable so they will change, usually along with the prime interest rate. If you pay more than the interest amount on the loan, you start to pay off the principal amount.
You can withdraw whenever you need it during the draw period.
When the draw period ends, you must pay the principal and the interest. The result is significantly higher monthly payments. You may no longer withdraw money from the HELOC.
Pros and Cons of an Interest-Only HELOC
An interest-only HELOC offers lenders several benefits but be aware of the drawbacks.
Pros
- Lower repayments: Since you’re only paying the interest on the borrowed amount, your initial payments are lower.
- Less-expensive financing: The interest on a HELOC is significantly lower than credit card interest or the interest you’ll pay on a personal loan.
- Flexibility: With a HELOC, you borrow what you need. You pay interest only on the amount you have borrowed. You decide how much or how little of the available cash to use.
- Possible tax benefits: Under certain circumstances, you may claim the interest on your tax return.
Cons
- Higher loan payments later: When the draw ends, you must start paying the principal. The result is increased loan payments.
- High risk: If, for any reason, you can’t pay, you risk foreclosure and could lose your home.
- Variable interest rates: HELOC interest rates are variable, so they will change with market conditions. If the rate rises, the loan may become unaffordable.
When Should You Get Interest-Only HELOC?
Interest-only HELOCs work very well under certain circumstances
- Home improvements: HELOCS can be perfect for home improvement projects. You withdraw money as you need it, and it’s an investment in your property.
- Emergencies: Sometimes emergencies, like major household repairs, demand more cash than you have. A HELOC can offer relatively low-interest cash when you need it most.
- Bridging finance: If you are buying a house before you’ve sold your current property, you may need funds to make a downpayment.
- Consolidate debt: Consolidating your high-interest debt over a longer-term loan may help you to reduce monthly financial pressures.
When Should You Avoid a HELOC?
A HELOC is not a fix-all. You should avoid them under the following conditions:
- Poor financial discipline: HELOCS offers borrowers easy access to funds. If you have a record of poor financial discipline, you could get into deeper debt with a HELOC.
- Uncertain income: You must have confidence that you can service the variable interest rate and pay back the principal when the time comes. If you don’t, you’ll put your home at risk of foreclosure.
- Funding living expenses: Funding everyday expenses from a HELOC is risky.
What to Do When the Draw Period Ends
When the draw period ends, you must start paying back the principal, along with the interest payments. Your payments are set to increase significantly, particularly if you haven’t repaid any of the principal during the draw period. You can no longer withdraw funds from the HELOC at this stage.
You must prepare for the increased payments. Get a copy of your statement to understand the outstanding amount and the new monthly payments. Budget for the increased payments. If you cannot afford them, contact your lender to discuss ways of spreading the burden.
How to Calculate Interest-Only Payments
Check your HELOC statement for the outstanding balance and the annual interest rate. To calculate the interest-only payments.
- Divide the annualized interest rate by 12 to get the monthly interest.
- Multiply the balance by the monthly interest to calculate how much you pay in interest each month.
You can also use a HELOC calculator.
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Alternatives to Interest-Only HELOCs
Sometimes you might look at an alternative funding source to HELOCs.
Home Equity Loans
Home equity is the difference between your home’s market value and the amount you owe on the property. A home equity loan releases the value you own in the property, so you can use it to finance long-term projects, like home improvements, investments or a college education. It is a fixed-term loan offering lenders a lump sum cash payment, using the property as collateral.
With a home equity loan, repayments start immediately. The interest rate is usually fixed, so you know what your payments will be each month.
Home equity loans can be a good alternative to interest-only HELOCs because the fixed interest rates and stable payments make it easier to budget. You won’t face the prospect of the principal payment when the draw period ends.
Home Equity Investments
Another way to access your home equity is through a home equity investment. Several companies offer this relatively new arrangement. If you have a large amount of equity in your home, one of these companies may buy it in exchange for a lump sum. The company would then own a share of your home’s equity, which would be released when you sell or refinance the home. No repayment is required until you sell or refinance the home. Not every homeowner is eligible. You must have significant equity in your home, and the company may need to conduct an appraisal of your home.
Cash-Out Refinance
Another home equity option is cash-out refinance. With this option, you replace your current mortgage with a new mortgage. You receive the difference between what you owe in your current mortgage and the loan amount in cash.
The interest rate on cash-out refinance agreements is generally lower than the interest you’ll pay for a HELOC. This could save you a considerable amount of money over the term of the loan. You can lock in the interest rate for the full mortgage term. This way, you’re assured of a known and unchanging payment schedule. Interest rates on HELOCs are variable, so there is always the risk of increased payment requirements.
Typically, refinanced mortgages are over a longer term than HELOC, so the monthly payments may be more affordable. On the other hand, closing costs on refinanced mortgages are higher, so you must ensure that you can recover the costs before you move out of your current home.
Personal Loans
A personal loan is an unsecured loan. There is no collateral on the loan, so the lender depends solely on your creditworthiness. A personal loan usually offers lenders smaller loan amounts. Typically, repayment terms are also considerably shorter, usually one to seven years. Shorter terms mean that you may pay less interest overall, depending on the interest rate. If you have a good credit rating, you may also qualify for a better interest rate than you’ll get on a HELOC. You can fix the interest over the term of your loan, so the monthly payments are known and fixed. Normally the personal loan application and approval process is quicker than a HELOC approval.
Access to Funds When You Need Them Most
In certain circumstances, an interest-only HELOC is a cost-effective and flexible way for homeowners to access funds when they’re most needed. An interest-only HELOC is not without its risks. Lenders should understand the implications and have a financial plan before entering into a HELOC arrangement.
Frequently Asked Questions
Can I make principal payments on an interest-only HELOC?
Yes, you can make principal payments. The interest portion is the lowest amount you must pay. Any amount you pay over the interest payment comes off the principal.
Are there tax benefits associated with an interest-only HELOC?
Depending on your circumstances, there may be tax benefits associated with an interest-only HELOC used for home improvements. Seek a tax consultant’s advice.
Can I use an interest-only HELOC to consolidate debt?
You can use an interest-only HELOC to consolidate debt. The interest rates may be lower than your credit cards, but you should weigh the benefits against the risks.