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Also known as a home equity line of credit (HELOC), this loan product gives you an allotted amount you can spend and a certain period of time to spend it — typically five or 10 years. With some HELOCs, you start paying it back right way, principal and interest included, month-by-month. But with an interest-only HELOC, you pay only monthly interest during that draw period, minimizing the size of your monthly payments. You're only responsible for the repayment of principal when the draw period ends.
- How Does an Interest-Only HELOC Work?
- When Should I Consider an Interest-Only HELOC?
- When Should I Avoid an Interest-Only HELOC?
- What Should I Do Once My Draw Period Ends?
How Does an Interest-Only HELOC Work?
With an interest-only HELOC, the minimum monthly payment during the draw period only covers the interest on the loan. For example, if you’ve borrowed $12,000 at a 5% annual interest rate, your minimum monthly payment will be $50 during the draw period.
Your loan balance will remain at $12,000 each month during the draw period so long as you’re making the minimum payment. However, you can always choose to make bigger payments to begin paying down the principal.
This differs from a standard HELOC, which has higher minimum monthly payments because the payment covers some of the principal balance as well as the interest. Assume that the HELOC in question has a 15 year repayment schedule (during the draw period) instead of an interest-only payment schedule. In this case, the $12,000 balance with a 5% would have a $95 minimum payment. That means the minimum monthly payment is nearly twice that of an interest-only HELOC.
However, the low payment on an interest-only HELOC won’t last forever. When the draw period ends, the repayment period begins. At that point, the minimum monthly payment will increases. For unprepared borrowers, the substantial increase in minimum payments could be a shock to their budget. But because a HELOC is secured by your house, you must make the minimum payments on the HELOC to avoid losing your home to foreclosure.
When Should I Consider an Interest-Only HELOC?
Most people consider interest-only HELOCs for the initial low monthly minimum payments, which give borrowers more flexibility with regards to their budgets. This makes them a good choice when you need to conserve your monthly income in the short-run, but expect significantly more income in the future, or intend to sell your property in a rapidly appreciating real estate market. Here are some common examples of when people may want to take out an interest-only HELOC.
Trying to Minimize the Monthly Payments on a Flip
In general, it makes sense to opt for an interest-only HELOC when you plan to move out of your house before the draw period ends. That way you can take advantage of the low monthly payments while you live in the house and pay off the line of credit when you sell.
For example, you may opt for an interest-only HELOC if you need to make repairs and renovations before you put your house on the market. While this tactic can have significant payoff, it may be risky if the real estate market turns against you by the time you intend to sell or your loan comes due.
Making a Down Payment on a Second Home Before Selling Your First
Another time an interest-only HELOC makes sense is when you’re using the loan as a bridge loan. In some cases, you can use an interest-only HELOC to put a down payment on a new house before you sell your existing home. However, lenders don't always allow you to obtain a HELOC, especially if a sale on the underlying property is inevitable. Keep in mind that you will likely be held responsible for all closing costs on the HELOC in the event the underlying property is sold within a few years of obtaining the loan.
When Should I Avoid an Interest-Only HELOC?
Keep in mind, an interest-only HELOC can be an especially risky product. Once you hit the repayment period, the minimum payment on an interest-only HELOC increases significantly. Borrowers who haven’t prepared for the increase can easily get into trouble.
For example, during the interest-only period, a HELOC with a $100,000 balance at 4% interest has a $333.33 monthly payment. Once the 20-year repayment period starts, that payment doubles to $606 per month. A nearly $300 monthly increase can be tough to handle in the best circumstances. If you’ve retired, working part-time, or had a partner drop out of the workforce to care for children or aging parents, it may impossible to make the new monthly payments.
What Should I Do Once My Draw Period Ends?
Once the repayment period begins, interest-only HELOCs typically allow you to repay the loan over a period of 10, 15 or 20 years. No matter what type of repayment plan you have, you have to make room in your budget to repay your interest-only HELOC.
These are six options to consider to pay off the loan. However, some HELOCs require a “balloon payment.” That means you have to repay the entire balance as soon as the draw period ends. This significantly limits your choices.
Make Monthly Payments
If you can afford the new monthly payments, pay them as agreed. This may cramp your budget, but it will allow you to become debt-free over time. Or better yet, if you have cash or other assets available to pay off your HELOC, consider using the money you have saved to pay off the HELOC completely.
Renew Your Line of Credit
Some banks allow you to renew your line of credit. This means you can start the draw period again and maintain your low monthly payments. Keep in mind that this will bring you no closer to paying off your loan and will actually increase your debt.
Refinance into a Home Equity Loan
A home equity loan is a fixed-rate loan that can be paid off over a period of several years. In some cases, these loans may offer better interest rates or better terms than HELOCs. Borrowers that have a balloon repayment should consider this as one of the most cost-effective options.
Complete a Cash-out Refinance
As a homeowner, you may qualify to refinance your existing mortgage and HELOC into a single mortgage. The ability to complete a cash-out refinance depends on your credit score, your income, other debts and the amount of equity you have in a home. A cash-out refinance of your HELOC has the added benefit of consolidating your home equity debt under the lower-interest rate of a primary mortgage.
Take Out a Reverse Mortgage
Seniors (age 62 and older) with substantial home equity may qualify for a reverse mortgage. A reverse mortgage can be used to pay off the remaining balance of a primary mortgage and the balance of the HELOC. Homeowners who cannot afford their monthly HELOC payments on a fixed retirement income, may wish to consider this option. The benefit of a reverse mortgage is that it avoids the need for any repayment until the owner leaves the property.
Sell Your House
Borrowers with plenty of home equity but limited income may find that selling their house is the best option. After selling, borrowers can use the proceeds from the sale of the home to pay off the HELOC and the primary mortgage.