Navigating the Benefits and Risks of Interest-Only HELOCs

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How Do Interest-Only HELOCs Work?

A home equity line of credit (HELOC) offers homeowners quick financing on an as-needed basis, which can be useful for home renovations or financial emergencies. An interest-only HELOC has an initial draw period where you can borrow funds while only making interest payments. After this period, you will start repaying the principal balance along with interest.

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

How Do Interest-Only HELOCs Work?

In some ways, a HELOC is similar to a credit card, as both come with a credit limit that determines how much you can borrow. However, unlike a credit card, a HELOC has a specific draw period, usually lasting 10 years, during which you can access funds. During this period, you are only responsible for making interest payments. After the draw period ends, you will begin repaying the total amount borrowed and can no longer draw from available funds.

HELOCs are known for offering competitive interest rates because the credit line is secured by your home, which serves as collateral.

Interest-Only HELOC vs. Traditional HELOC

With a traditional HELOC, you must pay interest and make payments toward your principal balance during the draw period, which could result in a hefty monthly payment if you borrowed a significant amount. Otherwise, interest-only HELOCs and traditional HELOCs are similar in that:

• Most charge a variable annual percentage rate (APR), meaning your interest rate and monthly payment may fluctuate over time.
• You need sufficient equity to qualify, typically 15% to 20% home equity.
• Your credit score matters, with most lenders requiring a minimum score of 680, though some may require a score in the 700s.
• Your overall financial health, including a low debt-to-income ratio (DTI), will be considered by lenders.

Should You Borrow With an Interest-Only HELOC?

Interest-only HELOCs might make sense if you have adequate home equity, strong credit, and:

• Experience a financial emergency 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.

It’s crucial to feel confident in your ability to repay the HELOC as promised, as failing to do so could put your credit and home at risk.

Pros of an Interest-Only HELOC

• You can borrow funds as needed during the draw period, providing greater financial flexibility.
• Interest rates tend to be lower than other options, such as credit cards and personal loans.
• You’re only responsible for interest payments during the draw period, resulting in a lower monthly payment.

Cons of an Interest-Only HELOC

• Your payment could spike after the draw period ends, as you’ll be responsible for repaying both principal and interest.
• Borrowing against your home equity will decrease the equity you’ve built.
• Your home is at risk if you default on your HELOC payments.
• Interest rates are usually variable, which could make budgeting difficult as your monthly payment may increase over time.

Interest-Only HELOC Alternatives

If an interest-only HELOC isn’t the right option for you, consider these alternatives:

• Traditional HELOC: You’ll make payments toward your principal and interest during the draw period, helping you pay off your debt faster.
• Home Equity Loan: Provides a lump sum of cash upfront that you repay over time, with lower interest rates than personal loans and credit cards.
• Cash-Out Refinance: Allows you to access some of your home equity when refinancing your mortgage, resulting in a new, larger loan.
• Personal Loan: An unsecured debt option with higher interest rates, typically used as a last resort.

The Bottom Line

An interest-only HELOC can provide cash on an as-needed basis, with the initial draw period typically lasting 10 years. After that, your monthly payment could increase significantly, and your home is at risk since it serves as collateral. Consider the pros and cons before deciding on an interest-only HELOC.

If you decide it’s right for you, you’ll need sufficient home equity and a strong credit score. For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your options and find the best solution for your financial needs.

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