What is an interest-only HELOC?

How does an interest-only HELOC work?

HELOCs are lines of credit secured by real estate. The real estate that secures the HELOC is typically the home where you live, a vacation home or a rental property. This line of credit has a maximum amount you can borrow, and it charges interest based on how much you’ve drawn down. The interest rate is based on the prime rate plus an additional margin (ex: prime plus 4%).

Steven Andrews, a real estate investor and author of "The New American Dream," said interest-only HELOCs "provide a ton of flexibility for the homeowner” and he would strongly recommend using them. He added that “you can always pay on the principal, too, but the interest-only payment structure gives you the flexibility if you can't pay on the principal one month."

You can draw from the HELOC as much and as frequently as you like, up to your credit limit. However, some banks may have a minimum draw amount per transaction. Draw methods typically include a debit card, checks and transfer requests either online, over the phone or in person at a branch.

As you repay the balance, your capacity to borrow increases. Payments are based on your average daily balance throughout the billing cycle. You can pay a higher amount, but the minimum monthly payment is interest-only during the draw period.

» LEARN: What is a HELOC, and how does it work?

Example of an interest-only HELOC

As an example scenario, say a home is worth $400,000, and the bank’s maximum combined loan-to-value is 85%. The borrower wants to get the largest HELOC they can get approved for. With an existing mortgage balance of $250,000, they can get a HELOC credit limit of up to $90,000 for a total debt of up to $340,000.

Once the $90,000 HELOC is approved, the homeowner can withdraw any amount up to their credit limit. On the first day, they take an advance of $24,000 at a 9% interest rate. When their statement arrives in 30 days, they’ll have a minimum payment of $180. This amount covers the interest that accrues, but it does not reduce the balance owed. To reduce future interest charges, they’ll need to make a larger payment to pay down the balance.

What to do when the draw period ends

Draw periods usually last for 10 years. If there is an outstanding balance at the end of the draw period, the HELOC converts into an amortizing loan, similar to a traditional mortgage. The interest rate and monthly payment become fixed based on the current rates, with a typical repayment period of 20 years. At the end of the 20-year repayment term, the balance will be completely paid off.

If there is an outstanding balance at the end of the draw period, the HELOC converts into an amortizing loan, similar to a traditional mortgage. ”

Some banks allow borrowers to fix some or all of their HELOC balance during the draw period. This converts the interest-only debt into a fixed-rate loan and is a good choice for people who desire a fixed monthly payment, want to lock in rates before they rise or want to pay off their balance in a certain time frame. Terms for these fixed-rate HELOC options typically vary from two to 10 years. Borrowers can select a repayment term that results in a payment that matches their ability to repay.

If you don't want your interest-only HELOC to convert to an amortizing loan, other options are available:

• Refinance into a new HELOC with a new draw period
• Refinance into a new home equity loan
• Pay off your HELOC balance
• Combine your existing mortgage and HELOC into a new mortgage
• Convert to a reverse mortgage (for eligible seniors)

Andrews recommended "renewing the HELOC by shopping around for the best deal. Getting a new HELOC provides flexibility if you ever need to use the money for other things.” He explained that he has used this strategy himself “numerous times when buying rental properties, and it works really well."

Pros and cons of interest-only HELOCs

With an interest-only HELOC, you pay only for what you use. Interest-only payments are based on your average daily balance. If you don’t draw from the HELOC, you won’t owe any interest. However, this form of financing also has variable interest rates. As interest rates rise, your monthly payment will go up. Depending on your budget, this can lead to financial distress.

Consider this full list of pros and cons of interest-only HELOCs before applying.

Alternatives to an interest-only HELOC

While interest-only HELOCs are an appealing financing option for many homeowners, they aren’t the best loan option in every situation and there are alternatives you can consider.

• Cash-out refinance. A cash-out refinance locks in your interest rate and generally offers lower rates than a HELOC or home equity loan. These mortgages are best for borrowers whose current interest rate is similar to currently available mortgage rates.
• Home equity loan. Getting a home equity loan provides a fixed interest rate and monthly payment with a defined repayment term. Home equity loans are ideal when you know exactly how much money is needed, such as for a home improvement project, debt consolidation or a similar loan request.
• Credit card intro APR offer. When you expect to be able to repay the money within one to two years, a 0% intro APR offer on purchases or balance transfers can be the best choice. These offers eliminate interest charges during the promotional period, but the interest rates are much higher if you cannot repay the debt before it expires.

» MORE: How to refinance a mortgage

When should you get a HELOC?

Home equity lines of credit provide incredible flexibility, and the money drawn from your equity can be used for almost anything. One of the biggest advantages of HELOCs is that they can be used repeatedly — as you repay the outstanding balance, your available credit increases. This makes HELOCs ideal for people with evolving borrowing needs or those who want to access money over longer periods of time.

With interest-only HELOCs, you can draw down the money as you need it. By comparison, a home equity loan or cash-out refinance provides a lump sum of cash, even if you don't need all of the money immediately. With these other loan types, you're paying interest on money that you aren't using.

HELOCs provide a huge advantage because you pay interest only on the money drawn from your line of credit. If you're doing a home renovation, paying for college tuition or helping to finance your business, HELOCs are an excellent choice because you can withdraw money as the need arises and pay only for what you're using.

If you have a tight budget, HELOCs are a smart choice. With interest-only payments, you'll have a smaller monthly minimum payment compared to amortizing loans like a mortgage or a home equity loan. As your finances improve, you can pay extra to decrease your balance. Paying down your balance not only reduces interest charges but also frees up available credit for future borrowing needs.

Bottom line

When you apply for a home equity line of credit, you can borrow as much or as little as you need up to a maximum credit limit. An interest-only HELOC requires monthly payments based on the current interest rates and your balance during the statement cycle. If your balance is zero, you won't incur any interest. During the draw period, you can withdraw money and repay it as many times as you like. When the draw period expires, any remaining balance converts to a term loan with a fixed interest rate that is typically repaid over 20 years.