Do You Pay Interest on a HELOC & How It’s Calculated
Understand how interest works on a Home Equity Line of Credit (HELOC). Explore calculation, payment impact, and tax considerations.
A Home Equity Line of Credit (HELOC) is a financial product that allows homeowners to borrow against the equity they have built in their property. It functions as a revolving line of credit, similar to a credit card, where your home serves as collateral. A common question is whether you pay interest on a HELOC; the answer is yes, interest is paid on funds utilized. This article will clarify the mechanics of HELOC interest, how it is calculated, and its tax implications.
How HELOC Interest is Calculated
Interest on a Home Equity Line of Credit (HELOC) is applied only to the amount of credit actually drawn, not the entire approved line. For example, if you use $20,000 of a $100,000 HELOC, interest is charged solely on that $20,000 balance. HELOC interest rates are typically variable, meaning they can change over time. These rates are often tied to a benchmark index, such as the prime rate, plus a margin determined by the lender. Fluctuations in the index rate directly affect the interest rate and monthly payments.
Interest on a HELOC usually accrues daily on the outstanding balance. Lenders calculate daily interest by dividing the annual interest rate by 365 and multiplying it by the daily balance. Daily interest charges are then summed for the monthly billing cycle. Some lenders may calculate interest monthly.
A HELOC operates in two distinct phases: the draw period and the repayment period. During the draw period (5 to 10 years), you can access funds as needed, up to your credit limit. Borrowers often have the flexibility to make interest-only payments or interest plus a small portion of the principal.
Once the draw period concludes, the repayment period begins (10 to 20 years). You can no longer draw funds and must make principal and interest payments until the balance is fully repaid. Monthly payments typically increase significantly during this phase as principal repayment becomes mandatory.
HELOC Versus Home Equity Loan
While both Home Equity Lines of Credit and Home Equity Loans allow you to borrow against your home’s equity, their interest application differs significantly. A Home Equity Loan provides a lump sum upfront. Interest accrues on the entire lump sum from disbursement. These loans typically come with a fixed interest rate, meaning monthly payments remain consistent and predictable throughout the loan’s term.
In contrast, a HELOC functions as a revolving line of credit. You only pay interest on the specific amount of funds you draw, not the entire approved credit limit. HELOCs predominantly feature variable interest rates, so the rate and your monthly payment can fluctuate with market conditions. This distinction in how interest is applied (lump sum versus only on drawn amounts) and the difference in rate structure (fixed versus variable) are primary factors distinguishing these two home equity products.
Tax Implications of HELOC Interest
Interest paid on a Home Equity Line of Credit (HELOC) may offer tax benefits under specific conditions. According to the Internal Revenue Service (IRS), interest on a HELOC can be tax-deductible if the borrowed funds are used to buy, build, or substantially improve the home that secures the loan. If HELOC funds are used for a kitchen remodel, a new roof, or an addition that increases your home’s value, the interest paid on those funds may be deductible. However, interest is generally not deductible if funds are used for purposes unrelated to home improvement, such as consolidating credit card debt or paying for college tuition.
Limitations apply to the amount of debt for which interest can be deducted. For loans taken out after December 15, 2017, the interest deduction is generally limited to debt up to $750,000, or $375,000 for married individuals filing separately. This limit applies to the combined total of home acquisition debt, which includes your primary mortgage and any home equity debt. Maintain thorough records of how HELOC funds are used to substantiate deductions. Consulting a qualified tax professional is advisable to understand your specific eligibility for deductions.