Do HELOCs Compound Interest?

A home equity line of credit, or HELOC, is the most popular way to convert home equity to cash, but there are several questions to ask before you sign off on one. It’s also important to understand potential risks of taking on home equity debt. 

The interest numbers you look at when you sign on a loan may look small, but they can add up to thousands, even hundreds of thousands, of dollars you’ll pay the lender over the course of the repayment period. 

Learning how HELOC interest works will help you make better-informed borrowing decisions.

Understanding HELOC Interest

HELOCs are an oddball when it comes to loan terms and how interest works—they can blend multiple interest accrual frequency and compounding methods vs. having a simpler and more consistent process of calculations throughout their contract life. 

How HELOCs Differ from Traditional Loans

The biggest difference with HELOCs is their two distinct phases: the draw period and the repayment period.

Think of it like a credit card that eventually transforms into a second mortgage. During the draw period (typically 10 years but can range from 5 to 15), you can borrow money as needed, similar to using a credit card.

Once the draw period ends, the HELOC enters the repayment period (usually 20 to 25 years), where it functions more like a traditional second mortgage—you pay back what you borrowed, plus interest. Each phase is entirely separate, and the way interest is handled may differ between the two.

• Draw period – Your monthly payments only have to cover interest on the current outstanding balance. This period typically employs a variable interest rate with simple interest calculated daily, but all of these factors can vary (or be negotiated) depending on lender and contract terms.

• Repayment period – Monthly payments include interest plus principal, and can either use a variable interest rate that calculates exactly what you owe each month (most common), or fixed rate for stable repayment amounts.

Simple vs. Compound Interest in Financial Products

Interest can be defined as the cost of a loan—the reason that a lender will extend funds to you in the first place, or the reason that you commit your cash to an institution via investments or banking in return for interest income. 

When you take out a loan, there are several factors that influence just how much interest you’ll pay over its duration. One such factor is the interest type, which can either be: 

• Simple – Interest is calculated on the loan principal only.

• Compound – Interest is calculated on both the loan principal and the accumulated interest of previous periods, often characterized as “interest on interest.”¹

If the interest type is compound, then you’ll also need to know the compounding period. The more frequently a loan is compounded, the faster it will grow. 

For example, the amount you’ll pay in total interest on a $50,000, 20-year loan at 12% fixed rate will differ simply based on how frequently it’s compounded²:

• Annually costs $77,034.80
• Semiannually costs $79,716.89
• Quarterly costs $81,144.16
• Monthly costs $82,130.34
• Daily costs $82,617.64

Do HELOCs Use Compound Interest?

While the answer is usually no, it comes down to the lender and contract terms, which could: 

• Utilize simple interest only
• Compound interest throughout the HELOC
• Limit compound interest to the draw period but not the repayment period

The more important question is—does your HELOC compound interest. Read the terms of your contract carefully and ask as many questions as it takes about what they mean and how they work before signing. This can help you avoid walking into a HELOC trap.

How Compound Interest Could Affect HELOCs

Compound interest multiplies your debt. If your HELOC agreement compounds interest, then the total amount you owe will continue to grow over time. 

Scenarios Where Interest Accumulation Increases Costs

At a basic level, the amount you pay in interest depends on how much you borrow and how long you take to repay it. When you consider a HELOC in particular, however, you’ll want to look at how your principal balance and interest accumulation interact with each period. 

Your costs will rise if you: 

• Max out your HELOC during the draw period
• Only pay interest during the draw period
• Follow the minimum repayment schedule during either period

Money borrowed from a HELOC that incorporates compound interest will continue to grow with interest on top of interest until you pay it all back, but you can reduce growth by giving it as much attention and care as possible during its lifetime. 

Managing Payments to Avoid Excessive Interest

Consider the monthly payment plan that your HELOC contract mandates to be a minimum rather than a goal. You can reduce your total interest paid by setting up: 

• Biweekly payments – Use biweekly rather than monthly payments throughout the life of the HELOC. These can benefit you both in the draw and repayment periods by chipping away at interest and principal more quickly. 

• Extra payments – Loans are set up to repay more interest (the lender’s cut) first before significantly reducing the principal balance. If you make additional principal-only payments, you can speed up the repayment process and reduce total interest paid.

Check with your lender and read your contract fine print to ensure they allow biweekly and extra payments or if any fees apply to early repayment.

Tips for Managing HELOC Interest Rates

Interest rates change over time based on the Federal Reserve’s federal funds rate and the prime rate set by the largest banks and financial institutions—those aren’t factors that you have any control over. But you do have quite a bit of control over the interest you pay based on individual choices and actions. 

Choosing Fixed vs. Variable Rates

While most HELOCs utilize variable rates both in the draw and repayment periods, you can also shop and negotiate for fixed terms for either or both periods. Making the best decision means spending some time doing the math and figuring out your comfort level with risk. In general³:

• Variable rates – Pros include lower initial interest rates and the potential for lower payments if market rates decrease. Cons include higher monthly payments and total interest paid if market rates increase. 

• Fixed rates – Pros include predictable monthly payments during the draw period, fully stable monthly amounts during the repayment period, and no impact to your loan if market rates increase. Cons include rates that are higher than an initial rate for a variable HELOC and no built-in ability to take advantage of savings if market rates decrease.

Strategies to Minimize Interest Payments

Although HELOCs are certainly more complex than a simple fixed-rate home equity loan taken in a lump sum, their variability also provides more flexibility and control over your monthly payments and total interest. 

To keep your interest payments low: 

• Maximize your repayments during the draw period vs. opting for interest-only payments
• Only use what you need when you need it—don’t overuse your line of credit
• Make frequent payments rather than monthly since interest is usually calculated daily
• If rates drop, refinance your HELOC or convert it from variable to fixed rate

You can also shoot for low rates by landing the best terms with these steps before you apply for a new HELOC:

• Check and improve your credit score 
• Calculate and lower your debt-to-income (DTI) ratio 
• Shop around, ask questions, and read the fine print to compare apples to apples

A Smart Alternative to HELOCs

Before you commit to taking on more debt to convert your home equity to cash, consider all your options. Truehold’s sell and stay transaction provides an alternative to HELOCs for homeowners in need of cash. Rather than paying the upfront and long-term costs of borrowing, working with Truehold brings together two real estate processes into one convenient transaction: a property sale and a rental lease agreement. 

When you sell to us, you get the best of both worlds. First, you remove the extra costs and work from the selling process. Instead of cleaning, repairing, and staging your home, you can simply schedule a no-cost home inspection with us at your convenience.  

Plus, you avoid the expense and disruption of finding a new home. A sell and stay transaction allows you to sign a rental agreement with us at closing, so you continue to live in your home seamlessly under the terms of the lease.* 

No loan interest, no moving hassle, and—to top it off—no more responsibility for homeowners insurance, property tax, or essential repairs. 

Ready to find out if we’re the right path for you? Call us any time and one of our representatives will reach out to answer your questions, review the process, and see if a sell and stay option fits your financial picture and goals.

Disclaimer*: After the home sale, you must comply with the terms of your lease to continue living in the home. This includes making timely payments on your rent for your minimum lease term (which ranges from 6 – 24 months).

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Sources: 

1. Investopedia. Simple vs. Compound Interest: Definition and Formulas. https://www.investopedia.com/articles/investing/020614/learn-simple-and-compound-interest.asp‍
2. Calculator.net. Loan Calculator. https://www.calculator.net/loan-calculator.html‍
3. LendEDU. How Is HELOC Interest Calculated? https://lendedu.com/blog/how-is-heloc-interest-calculated/‍