Interest-only payments vs fully-amortizing: What’s the difference?

A home equity line of credit, or HELOC, could be a good solution if you need to borrow money in a flexible manner. 

A HELOC is a revolving line of credit that lets you borrow against your home equity. You can borrow, repay, and borrow more, up to your limit, during a set draw period. Once the draw period is over, you can’t borrow additional funds.

Not all HELOCs work the same when it comes to making payments during the draw period. Many lenders allow you to make interest-only payments, while others require you to make interest and principal payments. Let's review the difference between these two types of HELOCs to understand how each works, as well as the pros and cons. 

What are interest-only payments?

Some HELOC lenders allow borrowers to make interest-only payment options during the draw period. This means you only pay the interest charged on the amount you've borrowed rather than making payments toward the principal balance.

For example, if you borrow $30,000 using a traditional HELOC, your monthly payments during the interest-only period only cover the accrued interest on that amount. Even if you pay for years, your balance remains at $30,000 unless you voluntarily pay more than your scheduled monthly payment.

Interest-only periods often last between five and 10 years, which is a common length of time for a draw period. After the draw period ends, the repayment period begins, at which point you start paying both principal and interest. Of course, your monthly payment will increase substantially once the interest-only period ends.

What are fully amortizing payments?

With a fully amortizing HELOC, you’ll pay both principal and interest each month from the start. This means that each payment you make gradually reduces the principal balance until the HELOC is fully paid off. This ensures you are structured  to pay off your HELOC in full by the end of the loan term.

For example, if you borrow the same $30,000 under a fully amortizing structure, each payment you make reduces the $30,000 you owe.

Fully amortizing monthly payments are bigger than interest-only payments. And you shouldn’t expect a significant payment spike when your repayment period begins unless you borrow more at that time. If you do borrow more, and therefore owe more, you’d have a higher monthly payment no matter what kind of payment your lender requires.

Benefits of interest-only payments

There are some benefits to interest-only payments:

• Lower payments in the near term. Only having to pay interest typically results in lower payments, freeing up cash flow.

• Flexibility. Keeping payments low could free up money for surprise costs, which can be helpful if you're using a HELOC for home renovations or if your income is temporarily lower than usual.

Drawbacks of interest-only payments

Interest-only payments have quite a few drawbacks:

• Payment shock. After the draw period ends, monthly payments can rise significantly as you have to start repaying both principal and interest over a shorter timeframe.

• Higher total borrowing costs. Paying interest for a period of time without reducing the principal balance generally means paying more interest over the life of the loan.

• Default risk. If your payments rise sharply because you haven't been paying down the principal, you could be at greater risk of falling behind. Defaulting on a HELOC could damage your credit score. In an extreme situation, it could also put you at risk of losing your home, since your home serves as collateral for your HELOC.

Benefits of fully amortizing payments

Fully amortizing payments offer these benefits:

• Consistent debt reduction. Because each payment lowers the principal balance, every payment gets you closer to paying off the debt.

• Frees up your line of credit. On a HELOC, paying down your principal frees up available credit that you could use again. You can borrow, repay, and re-borrow that same $30,000 as many times as you’d like during the draw period. That’s a big advantage over a one-time loan.

• More financial stability. If you're paying toward your principal the whole time, you can protect your budget from the big increase in payments (the “payment shock” mentioned above) that's commonly associated with interest-only HELOCs and which makes an interest-only HELOC inherently riskier.

• Reduced overall interest costs. With a fully-amortizing loan, less interest generally accrues over time, compared to an interest-only loan, saving you money.

Drawbacks of fully amortizing payments

Fully amortizing payments have one key drawbacks:

• Higher initial monthly payments. Since you're paying both principal and interest immediately, you will generally have higher monthly payments during the early stages of your loan.

Who interest-only payments are good for

Interest-only HELOC payments may be a good fit for borrowers who need lower monthly payments in the short term and feel confident they can afford the later payments that will be much higher.

The interest-only option may work well if you expect to sell your home soon and want to preserve your current cash flow. It might also be a viable strategy if you expect your income to increase but need lower monthly payments now. 

Who fully amortizing payments are good for

Fully amortizing HELOC payments can be the ideal option for borrowers who want to avoid a hamster wheel of debt, where you make payments but you don’t make progress. This structure is also a great choice for anyone who understands the potential burden of a sudden spike in the monthly payment amount. 

This option may work well for you if you:

• Earn a steady paycheck and are confident you can afford the payment

• Want to reduce your debt as quickly as possible

• Prefer a predictable repayment schedule

• Know that future payment increases could be stressful for you

• Want each payment to make a difference in your debt

Make the choice that’s best for your own wallet

Interest-only payments generally come with lower monthly costs initially, giving you more cash flow upfront. But they lead to higher long-term costs and sharp payment increases later, which could be risky. 

Fully amortizing payments generally require larger monthly payments initially. But they help you reduce debt steadily over time.

It’s a great idea to talk to a HELOC expert about how much you’re thinking about borrowing and what the payment would look like, so you can better understand what to expect after you apply.