What is an interest-only HELOC?

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A home equity line of credit, or HELOCcan be an effective way to leverage your home equity – especially today context of rising interest rates.

A HELOC is a revolving line of credit that you can access continuously over a period of years and works the same way as a credit card. One of the advantages of this type of loan is that most HELOCs have a interest-only drawdown period, which allows you to borrow a large sum of money for an extended period (usually 10 years) while making only minimal monthly payments. HELOCs also have variable interest rates, meaning the interest rate you pay changes over time – so make sure you can comfortably afford your payments if interest rates rise, as this will affect how much you’ll have to pay your lender each month.

Currently, the average HELOC rate is 6.75%, according to Bankrate, CNET’s sister site. If you are the owner, it is likely that the equity in your home has increased over the past two years, thanks to soaring home values ​​during the pandemic. If so, an interest-only HELOC may be a good choice for you.

Here’s what you need to know about interest-only HELOCs.

What is an interest-only HELOC?

It is a term that describes the drawing period of a conventional HELOCwhich typically gives you an interest-only upfront payment structure.

Once the drawdown period is over, your monthly payments will likely increase significantly, as you will need to start paying both interest and the principal balance of your loan. When the draw period ends, you enter what’s called the “payback period” – and that’s when your payouts will increase.

Keep in mind that whether a bank or lender will approve you for an interest-only HELOC will vary depending on factors such as your credit score, debt to income ratio and the loan to value ratio of your property.

With most HELOCs, as long as you’ve paid off your loan in full, you can also start drawing on your line of credit again.

What to do at the end of the draw period

At the end of your drawdown period, prepare for increased monthly payments. If you’ve only made interest payments, you might be in shock when your repayment period begins.

Most HELOCs have a variable interest rate that goes up or down based 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 level since 2008, and experts predict they will continue to climb until the end of the year.

What are the advantages and disadvantages of an interest-only HELOC?

The main advantage of an interest-only HELOC is that you can borrow a large sum of money for an extended period while making only minimum monthly payments. However, there are downsides to making interest-only payments, one being that you don’t reduce your principal balance. So, if you go the interest-only route at first, you will still owe your full loan amount even after years of making payments.

Advantages

  • Lower upfront payments: During the interest-only withdrawal period, your monthly payments are minimal, but increase when your repayment begins.
  • Low interest rate: Whether you have excellent credit you can get the lowest HELOC rates available, saving you thousands of dollars in interest over the life of your loan.
  • Long drawdown and refund times: A typical drawdown period can last anywhere from five to 20 years (usually 10 years). The repayment period is usually longer and can remain open for up to 20 years.

The inconvenients

  • Your HELOC is secured by your home: You pledge your house when you use an equity loan because you are borrowing against the value of your property.
  • Your payments increase after the draw period: Your monthly payments will increase, likely significantly, once you start making payments on both the principal balance and interest.
  • Variable interest rate: In a rising interest rate environment like the one we are experiencing today, a variable rate product can be riskier because your rate is more likely to rise and your monthly payments will also rise. If interest rates rise at the same time as your drawdown period ends, for example, you could suffer the double whammy of having to immediately pay a higher interest rate on a much larger loan balance, which could significantly increase your monthly payment.
  • Your rate is partly determined by your credit score: Whether you don’t have good credita HELOC may not make much sense financially: the lower your credit score, the higher the interest rate you’ll have to pay (since the bank considers you a higher risk to lend), negating one of the main advantages of a HELOC (the low interest rate).

Alternatives to an interest-only HELOC

If an interest-only HELOC isn’t right for your personal financial situation, there are other types of loans to consider, including other ways to leverage your home equity.

  • Home Equity Loan: A home equity loan is similar to a HELOC in that you borrow against your equity, but receive the funds in one initial 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%.
  • Refinancing by collection: A cash refinance may not make sense if your mortgage interest rate is lower than current rates, which have more than doubled to more than 6% since the start of the year.
  • Personal loans and credit cards: These types of loans generally have higher interest rates than HELOCs because they are unsecured loans, which means you don’t have to put your house up as collateral to secure the loan. This increases the risk for banks to lend to you, so they increase your interest rate. Currently, the average rate on a personal loan is 10.73%, according to Bankrate.

The bottom line

An interest-only HELOC is a convenient way to access funds, often at a relatively low interest rate. Most lenders require you to have at least 15-20% of the equity in your home to qualify for a HELOC. An interest-only HELOC is another term for the drawdown period you have during your HELOC, which is usually 10 years. Although not all HELOC draw periods offer interest-only payments for the first few years, most do. The advantage of an interest-only drawdown period is that you can borrow capital for an extended period while making only minimal payments.

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