What Is an Interest Only Home Equity Loan?

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An interest-only home equity loan typically takes the form of a home equity line of credit, or HELOC. Other types of home equity loans, such as lump-sum loans, generally don't offer an interest-only option. A HELOC allows you to access funds as you need them -- for example, twice a year to cover college tuition payments. The interest-only option allows you to make lower payments for a specified period.

Payments and Interest

Many HELOCs are interest-only loans, but only for an initial period, according to the Fair Isaac Corporation, which calculates credit scores. Once interest payments begin, the rate is typically adjustable, rather than fixed.

Interest-Only Advantages and Disadvantages

Interest-only loans have a couple of advantages:

  • A lower monthly payment during the interest-only period, which may be as long as 10 years. 
  • A lack of closing costs, according to Bankrate

The downsides of interest-only loans can be more numerous:

  • You don't increase your equity during the no-interest period by paying down the debt. If you home's market value decreases, you could lose equity.
  • At the end of the interest-only period, you'll typically have to start making larger monthly payments to pay back principal in addition to interest.
  • Some interest-only loans require a balloon payment. When the interest-only period is over, you'll owe a lump sum -- sometimes even the entire balance.
  • If you don't have enough money to pay a balloon or make larger payments, you'll need to refinance or sell when the interest-only period ends. Refinancing could be difficult if interest rates have increased or your home has lost value.

Qualifying for Home Equity Loans

Lenders set their own requirements for home equity loans, but you typically can borrow up to 80 or 90 percent of your home's value, including your first mortgage, according to Bankrate. For example, if you have a $70,000 primary mortgage on a $100,000 home, a $10,000 equity loan brings you up to $80,000 in debt, or 80 percent.

Lenders also apply different credit standards to qualify borrowers for home equity loans. Some lenders require a minimum FICO score of 620, while others require 660 to 680, according to Bankrate. Fair Isaac Corporation reports that you'll typically get a lower interest rate with a higher credit score.

Lenders also consider how much of your monthly income goes to repaying debt. Including credit card minimum payments, car loans, student loans and all mortgages, you're typically allowed to put approximately 40 percent of your monthly income toward debt payments.

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