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Interest-only HELOC: How payments are calculated
A home equity line of credit (HELOC) allows homeowners to access the equity they have built up in their home as a revolving line of credit. Because HELOCs are secured by using the home as collateral, they often have more favorable terms than other types of revolving credit, such as credit cards.
HELOCs have two distinct timeframes: the draw period and the repayment period. With an interest-only HELOC, the borrower is only required to pay interest during the draw period, which typically lasts 10 years. While this keeps monthly payments low during the draw period, costs can increase dramatically when an interest-only HELOC enters repayment.
Understanding how interest-only HELOCs work can help you decide whether they’re the right fit for your needs.
Learn more: How to get a HELOC in 6 simple steps
In this article:
How does an interest-only HELOC work?
Like a credit card, a HELOC allows you to borrow money up to the credit limit, repay the funds, and borrow again. However, unlike a credit card, you can only borrow money from a HELOC during the draw period, which usually lasts 10 years. Once the draw period is over, you can no longer withdraw money from the HELOC.
With an interest-only HELOC, homeowners are only responsible for making interest payments during the draw period. You do not have to make any payments toward your principal until the draw period ends and the repayment period begins.
The repayment period typically lasts 20 years. Once it begins, you must make monthly payments to repay the total amount you owe, which includes principal and interest. Borrowers who pay the minimum interest-only payments during the draw period can see payments increase dramatically once the HELOC enters its repayment period.
Many lenders allow you to make extra payments toward the principal with an interest-only HELOC — but you don’t have to.
How to calculate interest-only HELOC payments
To figure out your interest-only payments during the HELOC’s draw period, use the following formula:
[HELOC balance] x [annual interest rate] ÷ 12 = monthly interest-only payment
For example, let’s say you have drawn $25,000 from your line of credit and have an annual interest rate of 8.5%. Here’s how you would calculate your monthly interest-only payment:
($25,000 x 0.085) ÷ 12 = $177
So, your monthly payment during the draw period would be $177. However, most HELOCs have variable annual percentage rates (APRs), which means your interest-only payment may fluctuate over time as interest rates change.
Read more: How a fixed-rate HELOC works
What happens when the draw period ends?
Though you are only required to make this interest-only payment during the draw period, once it ends, your HELOC payments typically begin to amortize, which is a fancy way of saying you will be making installment payments to repay the loan balance over a set period.
These payments are divided between principal and interest. The portion allocated to paying off your principal starts low and increases over time, while the portion allocated to paying interest starts high and decreases over time.
Alternatively, your interest-only HELOC may require you to pay the full balance owed at the end of the draw period. This is known as a balloon payment. Before choosing a HELOC lender, verify with the company whether you will have a traditional repayment period or a balloon payment when the draw period ends.
Dig deeper: The best mortgage lenders right now
Interest-only HELOC vs. traditional HELOC
The main difference between these two types of HELOCS is that borrowers with a traditional HELOC must make both interest and principal payments during the draw period.
Otherwise, interest-only HELOCs and traditional HELOCs are basically the same. Both types require the borrower to have a minimum of 15% to 20% equity in the home. Both types usually have variable interest rates, meaning your payments may change over time — possibly from month to month. And both traditional and interest-only HELOCs are secured by the borrower’s home, meaning a default could lead to foreclosure.
Interest-only HELOCs are becoming much more common than “traditional” HELOCs these days, though. If you’re shopping for a HELOC, you’ll have an easier time finding a mortgage lender that offers the interest-only option.
Is an interest-only HELOC right for you?
While an interest-only HELOC has some major perks, it’s not right for every homeowner. Consider these potential benefits and drawbacks.
Pros
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Lower initial payments: The interest-only payments during the draw period will be lower than the later principal-and-interest payments during the repayment period.
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Lower interest rates compared to other revolving credit options: Credit cards’ minimum monthly payments can be affordable, but their interest rates are typically much higher than the rates on interest-only HELOCs.
Cons
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Pay more interest overall: Making only interest payments during the draw period means you will pay more interest over the life of the loan.
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Sudden payment increase: Borrowers may be overwhelmed by a sudden, higher monthly payment due at the end of the draw period.
Learn more: Yes, you can refinance a HELOC — here’s how
Interest-only HELOC FAQs
Can I make principal payments on an interest-only HELOC?
In most cases, yes. Check with your lender to see if you can make principal payments during the draw period on top of your required interest-only payments. Paying more during the draw period will reduce your balance and lower your monthly payments during the repayment period.
How long do you make interest-only payments on a HELOC?
If you have an interest-only HELOC, you can make interest-only payments during the draw period, which typically lasts 10 years. After the end of the draw period, borrowers who have only made interest payments will see their monthly payments go up during the repayment period.
Are there better options than an interest-only HELOC?
Depending on their specific needs, homeowners might consider a home equity loan, which offers a lump sum loan that is paid back monthly. They also might prefer a cash-out refinance, which allows them to access a lump sum of cash and gives them a new monthly mortgage payment. Both home equity loans and cash-out refinancing loans are available with fixed or variable interest rates. Some lenders also allow you to transfer some or all of your HELOC balance into a fixed-rate loan you pay back in monthly installments.
This article was edited by Laura Grace Tarpley.
