A home equity line of credit (HELOC) can be a great deal – if you can find one.
As people’s home values rise, HELOCs, which allow you to borrow the equity you’ve built up in your home and turn it into cash, are becoming harder to come by. Lenders are backing down and have even stopped taking HELOC requests altogether. Other banks only work with existing customers.
HELOCs aren’t the only way homeowners can tap into equity. If you have the ability to look around, cash-out refinancing might be a better option. but if you do decide to use a HELOC – and are able to obtain one – it’s best to understand the limitations and alternatives from the start. This type of financing requires research and planning on the part of the owner.
Here’s what to consider before getting one.
What is an interest-only HELOC?
A home equity line of credit is revolving debt that allows homeowners to borrow against the equity in their home. It begins with a drawdown period of between five and 10 years, followed by a repayment period of approximately 20 years.
With an interest-only HELOC, borrowers are only required to pay interest on the amount they withdraw during the drawdown period. Then, once they enter the repayment period, they have to make principal and interest payments.
“During the draw period, the revolving door swings back and forth,” said Bill Westrom, founder and CEO of Credit Line Banking and TruthInEquity.com, a financial advisory service. “Consumers have access inside and outside. If it is an interest-only drawing period. You only pay interest on the outstanding balance. This credit limit is an inexhaustible source of working capital as long as you repay it. At the end of the drawdown period, it becomes an interest and principal payment, and the door only opens one way. You repay the loan for the next 10 to 20 years.
You don’t have to wait for your repayment period to start paying down your HELOC principal. If you make regular principal repayments during your drawdown period, you will experience fewer payment shocks during repayment.
Interest-only HELOCs are generally variable rate loans. The rates are linked to the prime rate, which is the index used for many types of debt. As with other interest rates, it fluctuates with the rate set by the Federal Reserve. That means you won’t be able to lock in today’s low mortgage rates.
When does an interest-only HELOC make sense?
An interest-only HELOC is a way to borrow money at a favorable interest rate for purposes such as home renovations, debt consolidation, etc.
“Home equity lending can be a useful tool when used correctly,” said Melissa Cohn, executive mortgage banker at William Raveis Mortgage. “A home equity loan is good if you have one-time use of it. You have to buy something, pay taxes, etc. As long as you can manage the repayment, it’s a useful tool.
With mortgage rates so low, however, many homeowners are opting instead to access their home equity by refinancing their mortgage, which could generate cash and reduce interest on your entire mortgage. The number of refinance loans has increased dramatically, which is part of why HELOCs have been harder to get.
An interest-only HELOC is also not a good substitute for some other types of favorable financing. For example, some people use HELOCs to cover the cost of higher education. Those eligible for federal student loans should consider them first, says Leslie Tayne, debt relief attorney at Tayne Law Group.
When to Avoid an Interest-Only HELOC
While an interest-only HELOC can be a great opportunity, you need to understand the limitations.
First, this type of financing will not work for homeowners with little equity in their home. According to Westrom, lenders have become stricter about how much homeowners can borrow on. While they used to allow homeowners to borrow up to 100% of their home’s value, most now limit it to 80%. If you don’t have 80% of the equity in your home, you’ll probably need to consider alternatives.
You also need a solid credit score 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 applying. If your credit needs work, consider other options to build it up.
One very important thing to remember is that HELOCs are secured by your home. If you don’t repay the loan, the bank can foreclose on your home.
What to do when your HELOC draw period ends
At the end of your HELOC drawdown period, you will be required to make principal and interest payments on your line of credit. If you still have a balance on your HELOC at this time, you can expect to see your payment increase. Homeowners should start preparing early so they are ready for their new payment.
“Put the date in your calendar and set a reminder at nine months, six months, and three months before the start of the principal,” Tayne said. “Talk to your lender and find out what your payment could be. You need time to prepare.
In fact, the best way to prepare for the end of the draw period is to make payments from your main balance throughout the draw period. Just because you’re only required to pay interest for the first few years doesn’t mean you shouldn’t pay more. The more diligently you repay your HELOC during the draw period, the less payment shock you will experience when you enter repayment.
“Look at the principal and interest on a loan for the same amount of money,” Westrom said. “Make this payment on your HELOC or more. In this way, you decide the duration of the loan. Any extra money you put into the HELOC is still available to you. You can do more knowing you can walk away from it in an emergency.
Interest-Only HELOC Alternatives
An interest-only HELOC isn’t the only option available if you need money for property renovations, debt consolidation, or any other purpose. There are alternatives that people can turn to.
Refinancing by collection
Even though HELOCs may be the first thing to think of when considering tapping into your home’s equity, many experts suggest cash-out refinancing.
A cash-out refinance occurs when you take out a refinance loan that is larger than your current mortgage balance. Then you receive a payment equal to the difference between the previous balance and the new loan.
A cash refinance offers all the benefits of a mortgage, such as low fixed interest rates and a fixed repayment term. But unlike the interest-only HELOC, you can only borrow that money once. There is no revolving door like there is with a line of credit.
Home Equity Loan
Like a HELOC, a home loan lets you borrow against the equity in your home. A home equity loan, often referred to as a second mortgage, is not a revolving loan like a HELOC. Instead, you borrow a lump sum and then have a specific repayment term over which to repay it.
According to Cohn, these loans have advantages and disadvantages. “Interest rates are higher and payments are higher, but you don’t have any interest rate risk,” Cohn said.
Depending on your situation, a personal loan may be a better option. Unlike a HELOC, a personal loan is not secured by any collateral. So you don’t risk losing your home if you can’t make your payments.
On the other hand, because they are unsecured debts, personal loans usually have higher interest rates. Personal loan rates range from 4% to 36%. Check out NextAdvisor’s guide to the pros and cons of personal loans.