A HELOC is a revolving line of credit that you can continually access over a period of years, and functions similarly to a credit card. One of the benefits of this type of loan is that most HELOCs have an interest-only draw period, which allows you to borrow a large sum of money for an extended period of time (typically 10 years) while only making minimum monthly payments. HELOCs also have variable interest rates which means that the interest rate you pay changes over time -- so make sure you can comfortably afford your payments if interest rates rise, as that will impact the amount you’ll have to pay your lender every month.
Currently, the average rate for a HELOC is 6.75%, according to Bankrate, CNET’s sister site. If you’re a homeowner, it’s likely that your home equity increased over the past two years, thanks to skyrocketing home values during the pandemic. If so, an interest-only HELOC may be a good choice for you.
Here is what you need to know about interest-only HELOCs.
What is an interest-only HELOC?
It’s a term that describes the draw period of a conventional HELOC, which typically offers you an initial interest-only payment structure.
Once the draw period is over, your monthly payments will likely increase significantly as you must start paying back both the interest and the principal balance of your loan. When the draw period ends, you enter what is called the “repayment period” -- and that is when your payments will shoot up.
Keep in mind, whether a bank or lender will approve you for an interest-only HELOC will vary depending on such factors as your credit score, debt-to-income ratio and the loan-to-value ratio of your property.
With most HELOCs, as long as you paid your loan back in full, you can also start to draw from your line of credit again.
What to do when the draw period ends
When your draw period ends, be prepared for the increase in monthly payments. If you’ve only been making interest-only payments you could be in for sticker shock when your repayment period begins.
Most HELOCs have a variable interest rate that goes up or down depending on current interest rate trends, which will also impact how high or low your monthly payments are. Right now, interest rates are at their highest levels since 2008, and experts predict they’ll keep climbing through the end of the year.
What are the pros and cons of an interest-only HELOC?
The major benefit of an interest-only HELOC is that you can borrow a large sum of money for an extended period of time while only making minimum monthly payments. However, there are drawbacks to making interest-only payments, one being that you aren’t chipping away at your principal balance. So if you go the interest-only route in the beginning, you’ll still owe the full amount of your loan even after making payments for years.
- Lower initial payments: During the interest-only draw period your monthly payments are minimal, but they shoot up when your repayment begins.
- Low interest rate: If you have excellent credit you can secure the lowest rates available for HELOC, saving you thousands of dollars in interest over the lifetime of your loan.
- Long draw and repayment periods: A typical draw period can last anywhere from five to 20 years (usually 10 years). The repayment period is generally longer and can stay open as long as 20 years.
- Your HELOC is secured by your home: You put your home up as collateral when you use an equity loan because you’re borrowing against the value of your property.
- Your payments increase after the draw period: Your monthly payments will increase, likely significantly, once you must start making payments on both the principal balance plus interest.
- Variable interest rate: In a rising interest-rate environment such as the one we’re in today, a variable rate product can be riskier because it’s more likely that your rate will go, and your monthly payments will go up, too. If interest rates rise at the same time as your draw period is ending, for example, you could get hit with the double whammy of having to immediately pay a higher interest rate on a much larger loan balance, which could increase your monthly payment dramatically.
- Your rate is partially determined by your credit score: If you don’t have good credit, a HELOC may not make much financial sense -- the lower your credit score, the higher interest rate you’ll be required to pay (since the bank sees you as a higher risk to lend to), which cancels out one of the main benefits of a HELOC (the low interest rate).
Alternatives to an interest-only HELOC
If an interest-only HELOC isn’t right for your personal finance situation there are alternative types of loans to consider, including other ways to tap into your home equity.
- Home equity loan: A home equity loan is similar to a HELOC in that you’re borrowing against your equity, but you receive the funds in one upfront lump sum. Your interest rate is fixed rather than variable, so your monthly payments will always be consistent. The average interest rate for a home equity loan is currently 7.05%, which is slightly higher than the current average HELOC rate of 6.75%.
- Cash-out refinance: A cash-out refinance may not make sense if the interest rate on your mortgage is lower than today’s rates, which have more than doubled to over 6% since the beginning of the year.
- Personal loans and credit cards: These types of loans usually have higher interest rates than HELOCs because they aren’t secured loans, which means you don’t have to put your home up as collateral to secure the loan. That makes it a bigger risk for banks to lend to you, so they raise your interest rate. Right now, the average rate on a personal loan is 10.73%, according to Bankrate.