You’ve researched home equity products and determined that a HELOC is the best fit. Now, you have to decide between an interest only HELOC and a traditional HELOC. How do the two differ, and what are the eligibility requirements? More importantly, what are the key benefits and drawbacks of an interest only HELOC, and is it ideal for your financial situation? Read on to learn the answers to these questions and more to make an informed decision.
What is an Interest Only HELOC, and How Does It Work?
An interest only HELOC or home equity line of credit allows you to only pay interest during a set period. This is known as the draw period – typically spanning five to 15 years – and you can make withdrawals during this window as needed. As you make payments, the line replenishes, and you can continue to pull funds from the HELOC until the draw period ends.
It’s also worth noting that this HELOC is a revolving line of credit that operates similarly to a credit card. And it acts as a second mortgage that uses your home as collateral. So, defaulting on the HELOC could put your home at risk of foreclosure.
How Does an Interest Only HELOC Differ from a Traditional HELOC?
There are some key differences between standard and interest only HELOCs to be aware of.
Payment Structure Differences
- Interest only HELOC: You only pay interest during the draw period. Once it ends, your monthly payments are adjusted to include both principal and interest.
- Traditional HELOC: Payments include both principal and interest from inception.
Interest Accumulation
- Interest only HELOC: Interest is calculated on the amount you borrow during the draw period, and when it ends, interest is calculated on the remaining balance.
- Traditional HELOC: Interest charges are computed based on the principal balance. So, as it decreases, so will your borrowing costs.
Impact on Principal Balance
- Interest only HELOC: Unless you pay more than the minimum during the draw period, your principal balance will remain untouched until it ends.
- Traditional HELOC: Since you pay toward the principal balance from the start, the amount you owe will gradually decrease over time.
How is the Interest Rate Determined for an Interest Only HELOC?
Most HELOCs come with variable interest rates based on the prime rate, a benchmark that correlates to the federal funds rate. But if you get a fixed-rate HELOC, your interest rate will remain constant for the duration of the loan term.
Keep in mind that lenders sometimes add a margin to the prime rate they offer you. There are also introductory rates in some instances, which are lower on the upfront but adjust upward after the window ends.
Benefits of Interest Only HELOCs
Here are some key upsides to interest only HELOCs.
Lower Initial Payments
Since you’re only required to pay interest during the draw period, the initial payments on the HELOC will be much lower compared to a traditional HELOC. And they’ll be easier to manage and work into your monthly spending plan.
Flexibility with Finances
To piggyback off the last perk, you’re not limited to interest only payments. You also have the option to pay towards the principal during the draw period to minimize borrowing costs and get more affordable monthly payments once it ends.
Potential Tax Benefits
The interest you pay on an interest only HELOC could be tax-deductible if you use the home for qualifying home improvements. Speak with a tax professional to learn more or to determine if you’re eligible to take advantage of this benefit.
Drawbacks of Interest Only HELOCs
These home equity products also come with downsides to be aware of.
Risk of Higher Payments Later
The interest only payments during the draw period make these home equity products attractive. However, once the principal balance becomes payable, the minimum monthly payments could skyrocket. The variable interest rate could also mean steeper borrowing costs.
Potential for Overborrowing
You could be tricked into borrowing more than you can comfortably afford to repay since the initial payments are low. But keep in mind that choosing to pull funds from the interest only HELOC and not paying toward the principal balance could stretch your budget thin when the draw periods end and payments increase.
Impact on Home Equity
Pulling funds from your HELOC means denting your home equity until you repay the principal balance. If you borrow a sizable amount and property values dip, it could be challenging to refinance your home until you repay what’s owed. The same applies if you plan to sell your home and plan to turn a profit, especially if you are underwater on your home.
What are the Eligibility Requirements for Obtaining an Interest Only HELOC?
Before applying for an interest only HELOC, you should familiarize yourself with the eligibility requirements. Keep in mind that each lender has its own guidelines, so the criteria you’re subject to could be stricter or laxer.
Credit Score Requirements
A good or excellent credit score is ideal for qualifying for an interest only HELOC with competitive terms. More specifically, a score in the mid-to-high 600s or at least 700 could work with most lenders, as it demonstrates that you’ve responsibly managed debt obligations in the past. Keep in mind that some lenders may accept lower credit scores, but you may not qualify for competitive rates.
Home Appraisal
Lenders require a home appraisal to determine the current market value of your property. This figure is essential, as it determines how big of a HELOC you can qualify for. Most lenders cap this amount at 85% of your home equity, or the appraised value minus the amount you owe on the property.
To illustrate, assume your mortgage balance is $125,000 and your home appraises for $345,000. You could be eligible for a HELOC of up to $168,250 ($345,000 * .85 minus $125,000).
Debt-to-Income Ratio
Your debt-to-income (DTI) also plays an important role in your eligibility for an interest only HELOC. It is the percentage of your gross monthly income used to pay over-monthly debt payments. Lenders prefer a DTI under 43%, but you could be approved if the figure is higher if there are other compensating factors.
Interest Only HELOC Application Process
When you’re ready to apply for an interest only HELOC, here’s what to expect.
Preparing Financial Documents
The first step in the lending process is to gather the financing documents the lender will need to process your application. You’ll typically need recent pay stubs, tax returns and bank statements. Additional documentation may be required depending on the lender, so it’s worth inquiring before formally applying for an interest only HELOC so you’ll be prepared.
Choosing a Lender
Look for lenders specializing in HELOCs and have a track record of success in the mortgage industry. It’s equally important that the lender you select has positive reviews from past and current lenders. Also, ask about rates and fees to help you create a shortlist of viable options.
Ask about rates and fees, and get pre-qualified with at least three lenders so you can compare loan quotes and identify the best option.
Steps to Application Approval
Once you’ve gathered the necessary documents and selected a lender, it’s time to formally apply for an interest only HELOC with your chosen lender. Be sure to carefully review your entries to confirm their accuracy for submission and avoid an inadvertent denial.
If the lender determines you’re a good fit for an interest only HELOC, the next step is the appraisal. If all goes well, the lender will also review your credit history, income and debt load to make an offer to you.
The final step is to review and sign the loan documents to seal the deal.
Conclusion: When Is It a Good Idea to Get an Interest Only HELOC?
An interest only HELOC can make financial sense in many situations. If you have pressing short-term financial needs or cash flow issues,F it could provide much-needed relief quickly. Remember, you get lower payments during the draw period, which could be much easier to work into your budget.
That said, interest only HELOCs are not suitable for everyone, as they must be used strategically. You also need a plan in place to manage the fluctuations in monthly payments once the draw period ends and the repayment period begins.
Keep these factors in mind when deciding if an interest only HELOC is right for you. It could be best to explore other alternatives if you find that the potential costs of these home equity products outweigh the benefits.
