When to Avoid an Interest-Only HELOC to Tap Into Home Equity

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A home equity line of credit (HELOCs) can be a good deal — if you can find one. 

As the value of people’s homes are rising, HELOCs—which allow you to borrow the equity you’ve built in your home and turn it into cash—are becoming increasingly more difficult to get. Lenders are pulling back and have even stopped taking HELOC applications altogether.  Other banks are just working with existing customers. 

HELOCs aren’t the only way homeowners can tap into equity. If you have the option to look around, cash-out refinancing might be a better option. but if you decide to use a HELOC — and are able to get one — it’s best to understand the limitations and alternatives upfront. This type of financing requires research and planning on the part of the homeowner.

Here’s what to consider before you get one.

What Is an Interest-Only HELOC? 

A home equity line of credit is a revolving debt that allows homeowners to borrow against the equity they have in their homes. It starts with a draw period between five and 10 years, followed by a repayment period of about 20 years.

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

“During the draw period, the revolving door swings both ways,” said Bill Westrom, founder and CEO of Credit Line Banking and TruthInEquity.com, a financial consulting service. “Consumers have access in and out. If it’s an interest-only draw period. You only pay interest on the outstanding balance. That credit limit is an endless supply of working capital as long as you’re paying it back. At the end of the draw period, it becomes an interest and principal payment, and the door only swings one way. You’re paying the loan back for the next 10-20 years.”

Pro Tip

You don’t have to wait for your repayment period to begin paying down the principal on your HELOC. If you make regular principal payments during your draw period, you’ll experience less payment shock during repayment.

Interest-only HELOCs are typically variable-rate loans. 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 you won’t be able to lock in 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, and more. 

“The home equity loan can be a useful tool when it’s used properly,” said Melissa Cohn, an executive mortgage banker at William Raveis Mortgage. “A home equity loan is good if you have a single-purpose use for it. You need to purchase something, pay taxes, etc. As long as you can manage the repayment, it’s a useful tool.”

With mortgage rates so low, however, many homeowners are instead choosing to access their home equity by refinancing their mortgage, which could generate cash as well as lower the interest on your entire mortgage. The number of refinance loans has jumped significantly, which is partly why HELOCs have been harder to qualify for. 

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

When to Avoid an Interest-Only HELOC

While an interest-only HELOC can be a great opportunity, you must understand the limitations.

First, this type of financing won’t work for homeowners with little equity in their homes. According to Westrom, lenders have become more strict about how much equity homeowners can borrow against. While they used to let homeowners borrow up to 100% of their home value, most now limit it to 80%. If you don’t have 80% equity in your home, then you’ll likely have to consider alternatives.

You also need a strong credit score 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 applying. If your credit needs work, consider other options to build it up.

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

What To Do When Your HELOC Draw Period Ends

When your HELOC draw period ends, you’ll have to make payments on both the principal and the interest on your line of credit. If you still have a balance on your HELOC at that time, you can expect to see your payment increase. Homeowners should start preparing early so they’re ready for their new payment.

“Put the date in your calendar and set a reminder at nine months, six months, and three months before the principal kicks in,” Tayne said. “Have a conversation with your lender and find out what your payment might be. You need time to prepare.”

In reality, the best way to prepare for the end of the draw period is to make payments on your principal balance throughout the draw period. Just because you’re only required to make interest payments in the early years doesn’t mean you shouldn’t pay more. The more diligently you pay down your HELOC in the draw period, the less payment shock you’ll experience when you enter repayment.

“Look at the principal and interest on a loan for the same amount of money,” Westrom said. “Make that payment to your HELOC or more. That way, you decide on the loan term. All the extra money you put in the HELOC is still available to you. You can throw more at it knowing you can withdraw from it in an emergency.”

Interest-Only HELOC Alternatives

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

Cash-out refinance

Even though HELOCs might be first to mind when thinking about tapping into your home equity, many experts suggest cash-out refinancing.

A cash-out refinance is when you take out a refinance loan more than your current mortgage balance. Then you receive a payout for the difference between the previous balance and the new loan.

A cash-out refinance comes with all the benefits of a mortgage loan, such as low fixed interest rates and a fixed repayment term. But unlike the interest-only HELOC, you can only borrow that money once. There’s no revolving door as there is for a line of credit. 

Home equity loan

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

According to Cohn, these loans have both pros and cons. “The interest rates are higher, and the payments are higher, but you don’t run into 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 isn’t secured by any collateral. As a result, you don’t risk losing your home if you can’t make your payments.

On the other hand, because they’re unsecured debt, personal loans usually have higher interest rates. Personal loan rates vary from as low as 4% to as high as 36%. Check out NextAdvisor’s guide to the pros and cons of personal loan.