Are HELOCs Interest Only? How Payments Work
Discover the real nature of Home Equity Line of Credit payments. Understand how your HELOC balance and interest affect what you pay over time.
A Home Equity Line of Credit, known as a HELOC, provides a flexible way for homeowners to access the equity they have built in their property. It functions as a revolving line of credit, allowing borrowers to draw funds as needed up to a set limit, much like a credit card. Your home serves as collateral for this line of credit, which generally results in lower interest rates compared to unsecured loan options.
Understanding HELOC Payment Structures
Many HELOCs offer an interest-only payment option during their initial phase. During this period, borrowers pay only the accrued interest on the amount they have drawn. This payment structure can result in lower minimum monthly payments, providing borrowers with financial flexibility during the early years of the HELOC. While appealing for its affordability, the principal amount is not reduced through these minimum payments.
Borrowers might choose interest-only payments for various reasons, such as managing cash flow. Some lenders also allow borrowers to make payments towards the principal balance even during the interest-only phase, which can help reduce the overall debt and future payment obligations. This flexibility shows interest-only payments are an option, not the only type.
The HELOC Lifecycle: Draw and Repayment Phases
A HELOC operates through two distinct periods: the draw period and the repayment period. The draw period is the initial phase during which the borrower can access funds from the approved credit line. This period typically lasts between 5 to 10 years, though some HELOCs may offer draw periods up to 15 years. During this time, borrowers can withdraw funds as needed, repay them, and then redraw again, similar to how a credit card functions.
Once the draw period ends, the HELOC automatically transitions into the repayment period. At this point, borrowers can no longer draw new funds from the line of credit. Payments during the repayment period typically shift from interest-only to principal and interest (P&I) payments, amortized over the remaining loan term. This change often results in significantly higher monthly payments than those made during the draw period, as the borrower is now required to pay down the outstanding principal balance in addition to the interest. The repayment period typically ranges from 10 to 20 years, with some extending up to 30 years, depending on the lender and the initial terms of the agreement.
Variable Interest Rates and Payment Impact
Most HELOCs feature a variable interest rate, meaning the rate can change over time. This variable rate is generally determined by adding a fixed percentage, known as the margin, to a benchmark index rate. The Prime Rate, as published in sources like The Wall Street Journal, is a commonly used index for HELOCs, reflecting broader economic conditions and interest rate trends. Other indexes, such as the Secured Overnight Financing Rate (SOFR), may also be used.
Changes in the underlying index rate directly influence the interest charged on the HELOC, which in turn affects the monthly payment amount. For example, if the Prime Rate increases, the HELOC interest rate will also rise, leading to higher minimum payments, even if the principal balance remains the same. Conversely, a decrease in the index rate would lead to lower payments. These fluctuations can impact a borrower’s budget, especially once the repayment period begins and payments include both principal and interest. Some lenders may offer options to convert a portion of the variable-rate balance to a fixed rate, which can provide more payment stability.