Interest-only HELOC: Pros, cons, and how it works

You've decided a home equity line of credit (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 know there's 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 from the beginning.

Even with an interest-only HELOC, you'll need to repay what you borrow. It just comes a bit later, and the change in payment size could be a shock to your finances. Here’s what to know about how an interest-only HELOC works, when it might be right for you, and what to consider before you apply.

How an interest-only HELOC works

A home equity line of credit, sometimes called an interest-only equity line when it allows interest-only payments, 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 no longer draw from the credit line.

With an interest-only HELOC, the minimum payment during the draw phase covers only the interest on what you've borrowed. These interest-only payments don’t reduce the principal balance. Paying only the interest could give you much lower payments during the draw period. It also means the minimum payment will increase significantly once the repayment period begins and you start repaying your balance.

Here’s how the interest on a HELOC works: Interest typically accrues daily on your outstanding balance, based on your HELOC’s rate. Interest builds based on the amount you’ve borrowed, so you’ll pay more interest as you borrow more (and the longer you carry a balance).

When an interest-only HELOC makes 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 consolidate debt and free up extra cash in your monthly budget. If you’re paying off credit cards or other debt, you could consolidate it with a HELOC. Lower payments during the draw period let you put extra cash toward other goals, such as building 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. You’d need to pay off the full balance of your HELOC at closing, and you could use the proceeds from the sale for that. In this case, you’d be done with your HELOC before higher payments became 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 it could also pose risks.

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

Pros:

• The draw period has lower minimum payments, since you're only covering interest, not principal.

• You have greater short-term cash flow flexibility, which can free up money for other financial goals.

• You still have the option to pay down the principal at any time, on your schedule, without being required to. 

Cons:

• Your principal won't go down unless you choose to pay more than the interest, so your balance stays the same by default.

• Payment amounts increase when the repayment period begins, sometimes significantly, since principal payments kick in all at once.

• Your home serves as collateral, so if you don’t make your HELOC payments, you run the risk of foreclosure.

Risks of an interest-only HELOC

Every borrowing decision comes with trade-offs. Here are a few potential risks to keep in mind with an interest-only HELOC:

• Payments can increase significantly. The larger your principal balance, the more your payments could jump once the repayment period starts. If you’ve been planning your budget around interest-only payments, the increased payment amount could be a big adjustment.

• 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.

Interest-only HELOC vs. amortizing HELOC

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

This is also known as amortization, in which 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 could be a better fit.

How do you know if an interest-only HELOC is the right decision?

Choosing between an interest-only HELOC and your other options comes down to your goals, your timeline, and how comfortable you are with payments that change later. If predictable monthly payments are important to you, a fixed-rate HELOC or home equity loan could be worth exploring. 

Achieve Loans offers fixed-rate, fully amortizing HELOCs that could make budgeting easier than an option with changing payments. You can find out if you qualify with no impact to your credit.