What is an Interest-Only Home Equity Loan?

When considering types of home equity loans or lines of credit, it is important to weigh many different factors. Arguably the most important is the type of repayment required. An interest-only home equity loan requires the creditor to pay back only the interest accrued on the loan for a certain period of time designated by the lender. While the lower payment along with the tax-deductible mortgage interest is appealing, the drawback to an interest-only home equity loan is that no equity in the home is built during this time.

The structure of, and fees associated with, home equity loans can vary widely. Typically, a loan payment is comprised of principal and interest. Payments toward the principal of the loan pay back the actual amount borrowed, while the interest is the fee that the lender charges to loan the money. In an interest-only home equity loan, a debtor must pay back only the interest charged by the lender. This can be tempting to a borrower since no principal payments are required initially and the payments are lower.

Another advantage to a home equity loan is that it is considered a home mortgage, and the interest is tax-deductible. So in the case of an interest-only home equity loan, 100% of the payment can be deducted from taxable income. This can be a great idea for someone looking to reduce taxable income but not necessarily looking to build home equity.

One use of an interest-only home equity loan would be to use the money borrowed to increase the value of the home, building equity. If the loan is used for other purposes, it might be difficult to gauge the effectiveness of the loan in terms of increasing net worth. For example, if a homeowner obtains an interest-only home equity loan, and then uses the money to finance a business that fails, then borrower has nothing to show for the money for which he or she is still paying interest, and the principal is still owed.

The interest rate on any loan is of considerable importance to the borrower. Obviously, the lower the interest rate, the lower the payment required. As with any loan, a borrower's payment history and ability to repay are heavy factors that determine the interest rate. The interest rate on an interest-only home equity loan may also fluctuate with market rates. This can be an important factor when a borrower is planning for payments that will be required years from the time the loan is acquired.