What is an interest-only HELOC?

You've decided a HELOC is for you and now you're weighing your options. One lender offers an interest-only HELOC that promises lower payments during the draw period. Lower payments sound nice, but you're sure there has to be more to the story.

An interest-only HELOC is a home equity line of credit that allows you to pay only the interest on the amount you borrow during the draw period. This is different from a typical loan where payments cover both interest and the principal.

Even with an interest-only HELOC, you'll need to repay what you borrow—it just comes a bit later, and it can sometimes be a shock to your finances. Here's what to know about how an interest-only HELOC works, when it might be right, and what to consider before you apply.

How an interest-only HELOC works

A home equity line of credit is a revolving line of credit secured by your home. A HELOC has two phases: the draw period and the repayment period. 

During the draw period, which is usually five to 10 years, you can borrow, repay, and borrow again up to your credit limit as often as you like. After the draw period ends, you enter the repayment period and you can't draw from the credit line anymore.

With an interest-only HELOC, the minimum payment during the draw phase covers only the interest on what you've borrowed. In other words, you’re not reducing the principal balance. This could give you much lower payments during the draw period—but it also means your payments could increase significantly once the repayment period begins and you start repaying your balance.

When an interest-only HELOC could make sense

Here are two situations where using an interest-only HELOC for lower initial payments during the draw period could make sense:

• You want to unlock extra cash from your monthly budget. If you want to use your HELOC to consolidate debt, interest-only payments could give you some flexibility in your budget. Lower payments during the draw period let you put extra cash toward other goals—like paying off credit cards or building up emergency savings. 

• You plan to sell your home before the repayment period begins. Let’s say you expect to move within the draw period window. In that case, you may be able to use the proceeds from the sale to pay off the full balance of your HELOC at closing before higher payments become a factor.

Pros and cons of an interest-only HELOC

An interest-only HELOC may not be the right choice for every borrower or every financial situation. The flexibility of interest-only payments could be helpful for many people but may also pose risks. 

Here are a few advantages and tradeoffs of an interest-only HELOC: 

Pros

• Lower minimum payments during the draw period

• Greater short-term cash flow flexibility

• Option to pay down principal at any time, on your schedule

Cons

• No principal reduction unless you choose to pay more than the interest

• Payment amounts increase when the repayment period begins, sometimes significantly

• Many HELOCs carry variable interest rates, which means your payment could also get bigger if rates go higher 

All HELOCs are secured by your home, so having a strong repayment plan is key. If you don't make your payments as agreed, your home could be at risk.

Interest-only HELOC vs. amortizing HELOC

Not all HELOCs allow interest-only payments during the draw period. Many HELOCs require each payment to include interest and principal from the start. 

This is also known as amortizing, where each payment is split between interest and principal. Here's how interest-only and amortizing loans compare:

Not everyone wants or is prepared for some of the uncertainties of an interest-only HELOC. If the chances of higher payments or higher interest rates aren’t the right fit for your finances, an amortizing HELOC or a home equity loan with consistent payments may be worth exploring.

Risks of an interest-only HELOC

Every borrowing decision comes with tradeoffs. With an interest-only HELOC, here are a few potential risks to keep in mind:

• Payments can inflate significantly. The larger your principal balance, the more your payments could jump once the repayment period starts. Your HELOC is secured by your home. If you're not prepared for the jump, you could end up at risk of foreclosure.

• Variable rates could mean changing payments. Many interest-only HELOCs carry variable interest rates, which means your payment could rise if interest rates increase. This could make your HELOC payments even bigger during the repayment period if rates have increased and you have a large principal.

An interest-only HELOC has its place, but it's not right for every homeowner. If you want more predictable payments and less potential for payment shock, consider a fixed-rate HELOC such as one through Achieve Loans. Check your rate with no impact to your credit.