MMA loans

HELOC Interest Only Explained (Home Equity Line of Credit)

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A Home Equity Line of Credit (HELOC) can be a good deal – if you can find one.

As people’s home values ​​increase, HELOCs, which allow you to borrow the equity in your home and turn it into cash, are getting harder and harder to come by. Lenders are pulling out and have even stopped taking HELOC applications altogether. Other banks only work with existing customers.

HELOCs aren’t the only way homeowners can tap into equity. If you have the ability to look around, refinancing with withdrawal might be a better option. but if you do decide to use a HELOC – and you can get one – it’s best to understand the limitations and alternatives up front. This type of financing requires research and planning on the part of the owner.

Here’s what to consider before getting one.

What is an interest-only HELOC?

A home equity line of credit is revolving debt that allows homeowners to borrow against the equity in their home. It begins with a withdrawal period of between five and 10 years, followed by a repayment period of approximately 20 years.

In the case of an interest-only HELOC, borrowers are only required to pay interest on the amount they withdraw during the drawdown period. Then, once they enter the repayment period, they have to make both principal and interest payments.

“During the drawdown period, the revolving door swings back and forth,” said Bill Westrom, founder and CEO of Credit Line Banking and, a financial advisory service. “Consumers have access to the inside and the outside. If this is an interest-only drawdown period. You only pay interest on the outstanding balance. This credit limit is an infinite pool of working capital as long as you pay it back. At the end of the drawdown period, it becomes an interest and principal payment, and the door only opens one way. You pay off the loan for the next 10 to 20 years.

Pro tip

You don’t have to wait for your repayment period to start repaying the principal on your HELOC. If you make regular lump-sum payments during your withdrawal period, you will experience less payment shock during repayment.

Interest-only HELOCs are generally variable rate loans. The rates are tied to the prime rate, which is the index used for many types of debt. As with other interest rates, it fluctuates with the rate set by the Federal Reserve. This means that you will not be able to take advantage of today’s low mortgage rates.

When does an interest-only HELOC make sense?

An interest-only HELOC is a way to borrow money at a favorable interest rate for purposes such as home renovations, debt consolidation, etc.

“The home equity loan can be a useful tool when used correctly,” said Melissa Cohn, executive mortgage banker at William Raveis Mortgage. “A home equity loan is good if you have one-time use of it. You have to buy something, pay taxes, etc. As long as you can handle the repayment, this is a useful tool.

With mortgage rates so low, however, many homeowners instead choose to access their home equity by refinancing their mortgage, which could generate cash and reduce interest on your entire mortgage. The number of refinancing loans has increased dramatically, which is part of the reason HELOCs have been more difficult to obtain.

An interest-only HELOC is also not a good substitution for other favorable types of financing. For example, some people use HELOCs to cover the cost of higher education. People who are eligible for federal student loans should consider them first, says Leslie Tayne, a debt relief lawyer at the Tayne Law Group.

When to avoid an interest-only HELOC

While an interest-only HELOC can be a great opportunity, you need to understand its limitations.

First, this type of financing will not work for homeowners with little equity in their home. According to Westrom, lenders have become more strict about the amount of equity homeowners can borrow. While they allowed homeowners to borrow up to 100% of their home’s value, most now limit it to 80%. If you don’t have 80% of the equity in your home, you will likely need to consider alternatives.

You also need a strong credit rating and history. Lenders want to see a good track record of past loans and debts. Check your credit history and make sure it looks great before you apply. If your credit needs improvement, consider other options to develop it.

One very important thing to remember is that HELOCs are secured by your home. If you don’t repay the loan, the bank can foreclose on your house.

What to do at the end of your HELOC draw period

At the end of your HELOC withdrawal period, you will be required to make payments on both principal and interest on your line of credit. If you still have a balance on your HELOC at this time, you can expect your payment to increase. Homeowners should start preparing early to be ready for their new payment.

“Put the date on your calendar and set a reminder nine months, six months and three months before the principal takes office,” Tayne said. “Talk to your lender and find out what your payment might be. It takes time to prepare.

In fact, the best way to prepare for the end of the withdrawal period is to make payments on your principal balance throughout the withdrawal period. Just because you don’t have to pay interest for the first few years doesn’t mean you shouldn’t be paying more. The more diligently you repay your HELOC during the draw period, the lesser the payment shock you will experience when signing up for the refund.

“Look at the principal and interest on a loan for the same amount of money,” Westrom said. “Make this payment to your HELOC or higher.” This way you decide on the length of the loan. Any extra money you put into the HELOC is always there for you. You can throw in more knowing you can back out in an emergency.

HELOC interest-only alternatives

An interest-only HELOC isn’t the only option available if you need cash for a home improvement, debt consolidation, or any other purpose. There are alternatives that people can turn to.

Refinancing of collection

Even though HELOCs may be the first to think about when considering tapping into your home equity, many experts suggest refinancing with cash.

A withdrawal refinance is when you take out a refinance loan that is greater than your current mortgage balance. Then you receive payment for the difference between the previous balance and the new loan.

With cash-out refinancing comes all the benefits of a mortgage, such as low fixed interest rates and a fixed repayment term. But unlike the interest-only HELOC, you can only borrow this money once. There is no revolving door like there is with a line of credit.

Home equity loan

Like a HELOC, a home equity loan allows you to borrow against the equity in your home. A home equity loan, often referred to as a second mortgage, is not a revolving loan like a HELOC is. Instead, you borrow a lump sum and then have a specific repayment term to pay it back.

According to Cohn, these loans have both advantages and disadvantages. “The interest rates are higher and the payments are higher, but you don’t have any rate risk,” Cohn said.

Personal loan

Depending on your situation, a personal loan may be a better option. Unlike a HELOC, a personal loan is not guaranteed by any collateral. Therefore, you cannot risk losing your home if you cannot make your payments.

On the other hand, because it is unsecured debt, personal loans generally have higher interest rates. Personal loan rates range from 4% to 36%. Check out NextAdvisor’s guide to the pros and cons of a personal loan.