How Do Interest-Only HELOCs Work?

A home equity line of credit (HELOC) can provide homeowners with quick financing on an as-needed basis. This can be particularly useful if you have home renovations in the works or experience a financial setback and need cash quickly. An interest-only HELOC has an initial draw period where you can borrow funds while only making interest payments. After that, you’ll start repaying the principal balance along with interest.

Interest-only HELOCs have important drawbacks to consider, however. Here’s what you need to know.

Interest-Only HELOC vs. Traditional HELOC

With a traditional HELOC, you’ll have to pay interest and make payments toward your principal balance during the draw period. That could amount to a hefty monthly payment if you borrowed a significant amount of money. Otherwise, interest-only HELOCs and traditional HELOCs are the same in that:

• Most charge a variable annual percentage rate (APR). That means your interest rate (and monthly payment) may bounce up and down over time. In some cases, it could change from month to month.
• You’ll need sufficient equity to qualify. You’ll probably need 15% to 20% home equity to qualify for a HELOC. This is the amount of your home that you own outright, free and clear.
• Your credit score matters. Every HELOC lender is different, but you’ll likely need a minimum credit score of 680. Some lenders may require a score in the 700s.
• Your overall financial health will come into play. Most lenders will want to see a low debt-to-income ratio (DTI). This is the amount of your monthly income that’s going toward debt payments. A DTI that’s over 43% could be a stumbling block. You can also expect lenders to verify your income to ensure that you’re capable of repaying the HELOC.

Should You Borrow With an Interest-Only HELOC?

Interest-only HELOCs, which are more common than traditional HELOCs, might make sense if you have adequate home equity, strong credit and:

• Experience a financial emergency—like an unexpected home repair or job loss—and need cash quickly
• Plan to use the credit line to consolidate debt and save money in the long run
• Want to use a HELOC to make renovations that will increase your home value before selling

No matter what, you’ll want to feel confident in your ability to repay the HELOC as promised. Otherwise, it could put your credit, and your home, at risk.

Pros of an Interest-Only HELOC

• You can borrow funds as needed. Instead of taking out a lump-sum loan, you borrow funds when you need to during the draw period. This can provide greater flexibility with your finances.
• Interest rates tend to be lower than other options. As of July 2024, some HELOCs have rates as low as 8.5%. Credit cards and personal loans typically charge much higher interest.
• You’re only on the hook for interest payments during the draw period. This can result in a low monthly payment—sometimes for a decade. That might be a good thing if money is tight but you expect your financial health to improve in the future.

Cons of an Interest-Only HELOC

• Your payment could spike after the draw period. Once that interest-only period ends, you’ll be responsible for repaying your principal and interest. That could result in a much larger monthly payment than you had before.
• You’ll put a dent in your home equity. Your equity increases with every mortgage payment, but borrowing against your ownership stake will decrease the home equity you’ve worked to build. If your property value declines, you could end up owing more than your home is worth.
• Your home is on the line. With your home as collateral, you could lose your property if you default on your HELOC payments.
• Interest rates are usually variable. If interest rates start trending upward, your HELOC rate will probably do the same. That could make it harder to budget—and your monthly payment could grow larger over time.

Interest-Only HELOC Alternatives

You may decide that an interest-only HELOC isn’t the right financing option for you. In that case, one of these alternatives might be a good fit.

• Traditional HELOC: You’ll be responsible for making payments toward your principal and interest during the draw period, which can help you pay off your debt faster. And while your monthly payment could still fluctuate if you have a variable interest rate, you’ll avoid the sticker shock that can happen when an interest-only HELOC’s draw period ends.
• Home equity loan: This works like a HELOC but isn’t a line of credit. Instead, a home equity loan provides a lump sum of cash upfront that you repay over time. Interest rates tend to be lower than personal loans and credit cards because your home serves as collateral.
• Cash-out refinance: With a cash-out refinance, you can access some of your home equity when refinancing your mortgage. This will result in a new, larger loan than you had before. You’ll receive the difference in cash that you can use any way you want.
• Personal loan: This may be a last resort since interest rates can be as high as 36%. A personal loan is a form of unsecured debt, which means there’s no collateral behind it.

The Bottom Line

An interest-only HELOC can provide cash on an as-needed basis. You won’t have to start repaying your principal until after the initial draw period, which typically lasts 10 years. After that, your monthly payment could go up significantly. Your home is also at risk since it serves as collateral. This is all to say that you’ll want to consider the pros and cons before getting an interest-only HELOC.

If you decide that it’s right for you, you’ll likely need sufficient home equity and a strong credit score. You can check your FICO® Score and credit report for free with Experian.

For expert mortgage services and personalized advice, contact O1ne Mortgage at 213-732-3074. Our team is here to help you navigate your mortgage needs and find the best solution for your financial situation.