With all this equity available to homeowners, it makes sense to put it to work for home improvements, college expenses, vacations, or other major purchases. When it comes to borrowing against your home’s equity, you have a few options, including an interest-only home equity line of credit, or HELOC. But does an interest-only HELOC make sense for your particular needs?
What does “interest-only” mean?
HELOCs are popular because they’re highly flexible and usually offered at relatively low interest rates. Most are extended for a five- or ten-year term. Unlike a typical loan, the amount you borrow isn’t usually given to you in one lump sum. Instead, you borrow against your available loan amount as you need it. This is called making a “draw.”
With a HELOC, your monthly payment varies because it’s based on the amount you’ve drawn. For example, if you have a $10,000 HELOC, but you’ve only drawn $2,000, your payment is calculated on $2,000. With a typical loan, your monthly payment would be a set amount based on the entire $10,000 balance.
The minimum monthly payment due on an interest-only HELOC is just that — interest only. So, if you’ve drawn $2,000 on your HELOC, you’ll only be required to pay the interest due on that $2,000 that month. Of course, when you pay only the interest due, you aren’t paying anything toward your $2,000 balance.
How interest-only HELOCs benefit borrowers
Obviously, paying only the interest due on a loan — with nothing going toward the amount you borrowed — isn’t a great long-term strategy. Theoretically, you could pay interest monthly for the entire five- or ten-year term and still owe the same amount you started with. However, interest-only HELOCs make great sense for homeowners in certain situations.
Many homeowners will use an interest-only HELOC for short-term projects when they know they will be paying off the entire balance fairly quickly. Often this payoff becomes available when the homeowner sells the house or refinances their first mortgage.
For example, maybe you’re making upgrades to your home like updating your kitchen or adding another bathroom to increase the value of your home. A HELOC allows you to draw funds as you or your contractor need supplies or complete each part of your project. During this time you pay only the low, interest-only payment. When your upgrades are done, your house is worth more money, so you refinance your mortgage, borrowing enough to pay off the balance of your HELOC. Interest-only HELOCs are also a popular option for people who “flip” houses — those who buy houses to fix up and sell quickly for a profit.
Although you’re only required to pay the interest on your interest-only HELOC each month, you can also pay more than the minimum amount. Anything you pay above the interest that’s due will be applied toward your loan principal.
When interest-only isn’t a great idea
At the end of the initial term of your HELOC, it’s time to start paying your loan down. Your financial institution will amortize your remaining balance into a regular term loan, and your new minimum payment will be a set amount that includes portions for both interest and principal. This change from low interest-only payment to a significantly higher monthly payment is difficult for some people, and they have to look for other solutions.
Of course, when that time comes, you have a few different options. You can pay off the balance completely if funds are available, take out a new interest-only HELOC for another five- or ten-year term, or refinance your first mortgage to pay off the balance.
If you’re still not sure if an interest-only HELOC is the right loan product for you, reach out to your financial institution. They will help you find the perfect solution for your situation.