When to Avoid an interest-only HELOC to unlock home equity

A home equity line of credit (HELOCs) can be good business – if you can find one.

As the value of homes increases, it becomes more and more difficult to get HELOCs, which allow you to borrow and convert the equity you have built in your home into cash. The lenders withdraw and even no longer accept HELOC applications at all. Other banks only work with existing customers.

HELOCs aren’t the only way for homeowners to unlock equity. If you have the opportunity to shop around, cash out refinance may be a better option. However, if you are settling on a HELOC – and can get one – it is best to understand the limitations and alternatives beforehand. This type of financing requires research and planning on the part of the home owner.

Here’s what to consider before getting 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 begins with a drawing period of between five and 10 years, followed by a repayment period of around 20 years.

With an interest-only HELOC, borrowers only have to make interest payments on the amount they withdraw during the draw period. Once they enter the repayment period, they must make both principal and interest payments.

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

Pro tip

You don’t have to wait for your repayment deadline to begin repaying the principal of your HELOC. If you make regular principal payments during your draw period, you will experience fewer payment shocks during the repayment period.

Interest-only HELOCs are typically floating rate loans. Interest rates are tied to the base rate, which is the index for many types of debt. As with other interest rates, it fluctuates with the rate set by the Federal Reserve. That means you can’t cling to today’s low mortgage rates.

When does a HELOC that is only of interest make sense?

An interest-only HELOC is a way to borrow money at a low interest rate for purposes such as home renovations, debt consolidation, and more.

“The home loan can be a useful tool when used properly,” said Melissa Cohn, a senior mortgage lender at William Raveis Mortgage. “A home equity loan is good when it is only used for a single purpose. You have to buy something, pay taxes, etc. As long as you can manage the repayment this is a useful tool. “

However, with mortgage rates this low, many homeowners choose to access their home equity instead by refinancing their mortgage, which could both earn money and lower the interest rates on your entire mortgage. The number of refinancing loans has increased significantly, which is partly why HELOCs are more difficult to qualify.

An interest-only HELOC is also not a good substitute for some other cheap types of financing. For example, some people use HELOCs to help cover the cost of higher education. People eligible for government student loans should consider these first, says Leslie Tayne, a debt relief attorney with Tayne Law Group.

When to get a HELOC. should avoid only for interest

While a HELOC can be a great opportunity for interests only, you need to understand the limitations.

First, this type of financing doesn’t work for homeowners with little equity in their homes. According to Westrom, lenders have tightened on how much equity homeowners can raise. While they used to allow homeowners to borrow up to 100% of their home value, most now limit that to 80%. If you don’t have 80% equity in your home, you probably need to consider alternatives.

You also need a strong credit history and history. Lenders want to see a good track record of past loans and debts. Check your credit history and make sure it looks good before you apply. If your credit needs processing, consider other options to build it up.

One very important thing to remember is that HELOCs are secured from your home. If you don’t pay back the loan, the bank can foreclose your house.

What to do when your HELOC draw period ends

When your HELOC draw period ends, you will need to pay both the principal and the interest on your credit line. If you still have credit on your HELOC at this point, you can expect an increase in your payment. Homeowners should start preparations early so that they are ready for their new payment.

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

In reality, the best way to prepare for the end of the draw period is to pay your main balance during the draw period. Just because you only have to make interest payments for the first few years doesn’t mean you shouldn’t pay more. The more carefully you pay off your HELOC during the drawing period, the less payment shock you will experience when you make the repayment.

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

HELOC alternatives geared towards interest only

An interest-only HELOC isn’t the only option available when you need cash for a home renovation, debt consolidation, or other purpose. There are a few alternatives that people can turn to instead.

Cash-out refinancing

While HELOCs might come to mind when you think about tapping into your home equity, many experts recommend a cash-out refinance.

A cash out refinance is when you take out a refinancing loan that is more than your current mortgage balance. You will then receive a payout equal to the difference between the previous credit and the new credit.

Cash-out refinancing has all of the advantages of a mortgage loan, such as low interest rates and a fixed repayment period. But in contrast to the pure HELOC, you can only borrow this money once. There is no revolving door like there is with a line of credit.

Home loan

As with a HELOC, a home equity loan allows you to borrow against the equity that you have in your home. A home equity loan, often known as a second mortgage, is not a revolving loan like a HELOC. Instead, you borrow a lump sum and then have a specific repayment period over which to repay it.

According to Cohn, these loans have advantages and disadvantages. “Interest is higher and payments are higher, but you are not taking interest rate risk,” said Cohn.

Private loan

Depending on the situation, a personal loan may be the better option. In contrast to a HELOC, a personal loan is not secured by collateral. Hence, if you cannot make your payments, you don’t risk losing your home.

Personal loans, on the other hand, usually have higher interest rates because they are unsecured debt. Personal loan rates vary from just 4% up to 36%. Read NextAdvisor’s guide to the pros and cons of personal loans.