Everything You Need to Know About Interest-Only Home Equity Loans – You may have heard the term interest-only and wondered what it means when you’re talking about home equity loans.
This loan type, also known as an interest-only second mortgage, can be a useful tool to help homeowners borrow against their property to pay for large expenses like college tuition, home improvement projects, or other major costs of living.
Let’s take a look at how interest-only home equity loans work and some of the pros and cons that come with these types of home equity financing options.
What is an Interest Only Home Equity Loan?
An interest-only home equity loan is a type of home equity loan that allows you to receive funds against your house or property and pay it back over time with just interest.
These types of loans are extremely useful for people who are having trouble qualifying for other types of loans, as well as individuals who want flexibility with how they pay their loans back over time.
One way in which an interest-only home equity loan is different from other types of loans is that while many other mortgages have standard terms—such as 10-year repayment periods—an interest-only home equity loan can be structured differently based on what works best for you and your particular financial needs.
Learn more about how these loans work in Everything You Need To Know About Interest Only Home Equity Loans.
How Do I Qualify for an interest-only home equity loan?
To qualify for an interest-only home equity loan, you must have equity in your home. Most lenders will want at least 20 percent equity in your property and may require even more, especially if you are a first-time borrower or don’t have an excellent credit score.
In addition, most lenders will look at your ability to repay. This means they will check your income against any outstanding debts and other financial obligations. If you fail either of these requirements, you may be forced to take out a fixed-rate mortgage or consider another financing option instead.
What Type of Property Can I Use For My Interest-Only Loan?
One of the first questions that people ask when considering an interest-only home equity loan is what type of property can I use for my interest-only loan.
The short answer is, it doesn’t matter. The property that you use for your interest-only home equity loan does not have to be your primary residence (although it can be).
It also does not have to be a personal residence at all; some people choose a vacation home, while others opt for investment properties.
As long as there is sufficient equity in your property and you meet all other criteria (be sure to check with your lender), you’ll likely qualify for an interest-only home equity loan.
What Are The Benefits Of An Interest-Only Loan?
One of the biggest benefits of taking an interest-only loan is that you can increase your monthly cash flow.
This means that you may be able to upgrade certain areas of your home, start paying off debt, or make additional investments.
With a regular 30-year mortgage, you have to make payments on both interest and principal during each repayment cycle (typically 12 months).
That means that you are spending money on your mortgage twice every year. With an interest-only loan, those payments only go toward interest, which allows you to put more cash into other investments or pay off other debts.
When Can I Refinance To A Traditional Mortgage?
If you are in a hurry, an interest-only home equity loan can serve as an excellent stopgap. To qualify for one, you must have access to substantial home equity and enough income (most lenders require at least $1000/month).
It’s not meant as a permanent solution, however—interest-only loans typically only last 5 years and your payments will jump substantially when they expire.
At that point, you’ll need to either pay off your loan or refinance into a traditional mortgage.
If your house has increased in value during that time, it might make more sense just to refinance directly into a new 30-year fixed-rate mortgage at that point; otherwise, you could find yourself upside down on your home again if market conditions change substantially in those five years.
Should I Get a Second Mortgage Or Cash Out?
One common question we get asked is, Should I get a second mortgage or cash out? That’s an important question and it should be addressed with some nuance.
The first thing you need to think about when asking that question is what your loan-to-value (LTV) ratio is on your primary mortgage.
If you’re thinking of getting a second mortgage on your home, make sure you know whether you have 20% equity in your home based on current market prices. It’s not uncommon for home values to appreciate more quickly than interest rates—meaning borrowing may become cheaper over time.
And if that happens, taking out a second mortgage will only cost you more in interest payments over time.
My Home Is Worth Less Than I Owe. Can I Still Get an Interest-Only Loan?
We have a lot of readers who are looking for interest-only loans, but who are at risk of foreclosure or bankruptcy.
If your home is worth less than you owe, then you might be able to use an interest-only loan—but only with special qualifications.
When you apply for an interest-only loan with a lending company, they will ask whether your home has declined in value since you bought it. If so, and if it’s declined by more than 20%, then they may not be willing to give you an interest-only mortgage.
What If My House Drops In Value After I Take Out The Home Equity Loan?
Although interest-only home equity loans do not require any payment of principle, they do require interest payments, just like a mortgage.
If your home value drops, you could end up owing more on your home than it is worth and need to sell it or risk foreclosure.
That’s why you should only get an interest-only home equity loan if your house is worth at least 80% of what you owe on it.
This way, if your home ever dropped in value below 80% of what you owe on it, you could still sell without having to pay anything off immediately.
Will A Second Mortgage Affect My Credit Score?
The answer really depends on a variety of factors, but there’s no doubt that a second mortgage can hurt your credit score.
Some mortgages are unsecured loans, meaning you don’t put down a single penny of your own money when you take out the loan.
If you take out an unsecured loan, it won’t have any impact on your credit report or credit score.
However, if your second mortgage is secured by your home equity and isn’t paid off in full at some point during its lifetime, there’s every reason to believe it will affect your credit history.
What if I sell my home before the term is up?
This is an excellent question and it’s likely one that you should consider before you buy any interest-only loan.
Keep in mind that if you sell your home before paying off your HELOC, then you could lose out on some of those payments—or worse, owe more than your home is worth.
It’s important to be aware of these risks so that when a good opportunity comes along, you can make an informed decision. What if I sell my home while I still have debt left on my loan?:
Once again, if you sell your home with an outstanding balance on a HELOC, then there are risks involved.
