An adjustable-rate Home Equity Line of Credit (HELOC) lets you borrow against your home’s equity with a variable interest rate that fluctuates with market conditions. Unlike a fixed-rate loan, the interest on an adjustable-rate HELOC changes as benchmark rates (like the U.S. Prime Rate) move, which affects your monthly payments.
How Does an Adjustable-Rate HELOC Work?
An adjustable-rate HELOC typically has two phases:
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Draw Period (usually 5-10 years): During this time, you can borrow funds up to your credit limit as needed. Payments are generally interest-only, keeping them low initially.
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Repayment Period (often 10-20 years): After the draw period ends, you can no longer borrow. You must repay both principal and interest, with payments recalculated to pay off the balance by the end of the term. This can cause a significant increase in monthly payments, known as “payment shock.”
Interest Rate Structure
The adjustable rate is calculated as the sum of:
- Index: A market-driven benchmark rate (commonly the Prime Rate).
- Margin: A fixed percentage added by the lender, set in your loan agreement.
Lenders usually include caps that limit how much your rate can increase periodically and over the life of the loan to protect borrowers from extreme rate hikes.
Pros and Cons
| Pros | Cons |
|---|---|
| Flexible borrowing and interest-only payments during the draw period allow for manageable monthly costs. | Variable interest rates mean monthly payments can increase, complicating budgeting. |
| Generally lower initial rates than fixed-rate loans. | Principal repayment phase can lead to substantial payment increases. |
| Ability to borrow repeatedly during the draw period. | Your home serves as collateral, risk of foreclosure if payments aren’t met. |
Who Should Consider an Adjustable-Rate HELOC?
This option fits homeowners who need flexible access to funds for expenses like home renovations or education costs and who can handle potential increases in monthly payments. It is best for disciplined borrowers with stable finances and an emergency fund.
Tax Deductibility of Interest
Interest on a HELOC may be tax-deductible if the funds are used to buy, build, or substantially improve the home that secures the loan. Personal expenses like paying off credit cards or buying a car do not qualify. For detailed IRS guidance, see IRS Publication 936.
Related Topics
Learn more about Home Equity Line of Credit (HELOC) and Home Equity Loan Interest Deduction for comprehensive insights.