If you have equity in your home, you may have a use for it. Whether you need debt consolidation or have home renovations on your mind, a home equity loan might be a good choice. However, you have choices. There is a home equity loan and an interest-only home equity line of credit.
The loan works like most loans. You receive the funds at the closing and you make regular principal and interest payments each month. A line of credit works like a credit card. You obtain access to the funds at the closing, but you do not necessarily use them. They sit in an account until you need them. As you pull funds out of the account, you make interest-only payments on the funds. This goes on for the first 10 years. After the “draw” period, you make principal and interest payments and no longer have access to the funds. The home equity loan is rather straightforward. However, the line of credit has special considerations.
The Payment Adjusts
Have you ever heard the term “payment shock”? It occurs when your housing payment increases dramatically from what you usually pay. Lenders use this term often with first-time homebuyers who only pay rent. The lender compares the borrower’s current rent payments to the new mortgage payment to see how much the payment goes up or how much “shock” the borrower experiences.
This payment shock is what you may experience with a home equity line of credit. After the initial 10-year period, your payment increases somewhat drastically. Rather than paying just interest, you now owe principal and interest. The difference between this payment and the payment on a regular loan is the amortization period. Yes, the HELOC has a 30-year term, but during the first 10 years, you paid interest only. Now you only have 20 years left to pay the principal. This means higher payments.
You May Pay Higher Interest Rates
Every lender differs in what they offer, but many lenders increase the interest rate for interest-only loans. This is because of the risk involved. If you do not pay any principal down on a loan, you never have any “skin in the game.” This could make you less motivated to pay your loan in full. However, if you make your first mortgage payments on time, chances are you will make your second mortgage payments on time too. It is not uncommon for home equity line of credit loans to have an interest rate that is 1/8 higher than other home equity loans, though.
You Get a Lower Payment
There are times when a HELOC with interest-only payments makes sense. A few of these instances include:
- On an investment home that you do not intend to keep long
- On a primary residence you plan to sell in a few short years
- If you have a job with low income now, but know the income will increase in the future
- You need money in a liquid asset rather than tied up in a home
The lower payment does offer its benefits. If you own a home you will not own for long, whether investment or your primary home, why pay more than you have to on it? Making interest only payments allows you to invest the rest of the money elsewhere. This way you can do with it as you need when you decide to sell and/or move.
Lower payments also help when money is tight. Maybe you have a job that will get better over time, such as when you have to work your way up the corporate ladder. Alternatively, you have a seasonal job that makes money tight during certain times of year. Having that lower payment can allow you to make the changes you want to your home or consolidate your debt, without breaking the bank. Just remember that the payment will adjust at a specific time. Make sure you are prepared for that time!
You Can Refinance an Interest Only Home Equity Line of Credit
Keep in mind, you are not stuck with an interest-only home equity line of credit for the rest of your life. If you know the loan will adjust to principal and interest shortly, go ahead and refinance. If you are not underwater and your credit is good, you may have a good chance at refinancing. This way you can pay off the HELOC and take out a fully amortized loan. What you should not do, however, is take out another HELOC. Some banks may offer this, but you just keep putting off the inevitable. Eventually you will retire, do you really want to still have HELOC payments when you are supposed to be enjoying your life?
Deciding whether an interest-only home equity loan is the right choice for you is a personal decision. Weigh the pros and cons of the situation. Then look at your plans. Is this your forever home or will you move soon? Is this an investment home that you will flip soon? Do you need the lower payment right now until you figure things out? Are you opposed to refinancing in the future before the loan adjusts? These are the questions you need to ask yourself to help you make your decision. The HELOC is not always a bad decision, but it can be if the timing is not right. Look at the full implication of the loan and compare it to your options to determine the right choice for you.