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A home equity line of credit (HELOC) allows you to tap the equity in your home and use the proceeds for any purpose you want. Many people use HELOCs to pay off high-interest credit card debt or finance home improvements.
HELOCs are a type of revolving credit that works sort of like a credit card. During the draw period, you can borrow money up to your predetermined credit limit and repay only the interest on the amount borrowed. Once the draw period ends, typically between five and 10 years after the HELOC is approved, you must start repaying both principal and interest. The popularity of HELOCs has grown recently as rising mortgage interest rates make cash-out refinancing less appealing.
But is a HELOC right for you? Understanding how HELOC repayment works can help you make that decision.
When Do HELOCs Enter Repayment?
The specific details of HELOC repayment vary by lender, but here's how the process generally works.
During the draw period, which usually lasts from five to 10 years, you can draw money from the credit line up to your credit limit. For example, if you have a $50,000 HELOC, you might borrow $10,000 in one year of the draw period, $15,000 the next and never draw from the HELOC again. During the draw period, you'll make monthly payments covering the interest on the amount you borrowed.
Once the draw period is over, your line of credit is closed and you can no longer draw from the HELOC. Typically, you'll have 20 years to repay the loan balance. However, some HELOCs require a balloon payment of the entire balance plus accrued interest when the draw period ends.
Even without a balloon payment, your monthly payments will increase substantially compared to the interest-only payments you made during the draw period. Be prepared for payments that can more than double compared to your interest-only payments.
Your payments could also increase or decrease if your HELOC has a variable interest rate, as many do. HELOC interest rates are tied to publicly available indexes, such as the prime rate, and rise and fall along with the index. Most variable-rate HELOCs set caps on how much your interest rate can increase from one adjustment to the next, as well as how much it can increase over the life of the loan. Your loan agreement should specify how the interest rate is determined and how rate increases are capped.
Your lender will determine your monthly payments based on your HELOC's interest rate, the amount you've borrowed and whether you're in the draw or repayment period. During the draw period, you'll make monthly payments of the interest on the amount borrowed from the HELOC. Once repayment begins, your monthly payments will cover principal plus accrued interest to pay off the total amount borrowed by the end of your repayment term.
How Can I Reduce My HELOC Payments?
Some HELOCs let you make payments toward principal during the draw period. If your loan allows it, doing this will lower your payments during the repayment period by reducing the balance you'll need to pay off. Review the terms of a HELOC before you accept it to see if you can repay principal during the draw period and if so, whether the HELOC charges prepayment fees.
Are you worried you may not be able to make your payments during the repayment period? There may be other ways to lower your payments. Start investigating before the draw period ends so you have time to consider all your options.
- Convert: If you have a variable-rate HELOC, you may be able to convert some or all of your outstanding balance into a fixed-rate loan. Your monthly payments will stay the same over the repayment period. This can make it easier to budget for them than the up-and-down payments of a variable-rate HELOC.
- Renew: Some HELOCs let you renew your credit line when the draw period ends. You reapply for a new HELOC and use its proceeds to pay off the old one. You then enter a new draw period and continue paying only the interest on the amount borrowed.
- Refinance: If you have enough equity in your home, you might be able to refinance your HELOC using one of two methods.
- Home equity loan: Like HELOCs, home equity loans use your home as collateral. Since they're installment loans, however, you'll make fixed payments over time, which could be more manageable than a HELOC's varying repayments. Use the proceeds of the home equity loan to pay off the HELOC.
- Cash-out mortgage refinance: Take out a new mortgage for more than your old one and use the difference in cash to pay off the HELOC. Getting a cash-out refinance only makes sense if the new mortgage has a lower interest rate than your HELOC and your current mortgage.
Can You Pay Off a HELOC Early?
If you want to pay off your HELOC early, check your loan terms first. Most HELOCs allow for early repayment without penalties. However, some charge a penalty that may be a flat fee, a certain amount of interest or a percentage of your outstanding balance. Your loan documents will explain how any penalties are calculated. If the HELOC has a prepayment penalty, you'll need to consider whether the potential savings in interest outweighs the penalty.
When paying off your HELOC early, you'll need to indicate to your lender that extra payments should go toward your principal, not interest. Check with your lender to see how to do this. Put enough money toward principal and you can pay off the entire HELOC during the draw period. Then, when the draw period is over, you'll have a zero balance, and the loan will close.
The Bottom Line
Making your HELOC payments on time can help improve your credit score, which can give you more options when looking for credit. Whether you're considering a HELOC for the first time or want to refinance an existing credit line, checking your credit report and credit score first will alert you to any potential problems. Paying down debt and keeping your credit utilization low can help boost your credit score, making it easier to qualify for HELOCs and other types of financing.