You want to pay off your mortgage but lack the funds to cover what you owe. A home equity line of credit (HELOC) could provide the cash you need, but is it a smart financial move? It depends on what you owe, current rates, and the equity you have in your home. Read on to learn more about the pros and cons of using a HELOC to pay off your mortgage and how to determine if it is the right choice for your financial situation.
How a HELOC Works
A HELOC is a revolving line of credit that operates similar to a credit card. You get access to a pool of cash based on the equity you have in your home and can withdraw from it as needed up to the limit during the draw period.
Most lenders require interest-only payments during the draw period, although you’re welcome to pay more than this amount. The line replenishes as you make payments, so you can re-use it as needed.
The draw period typically lasts between five and 10 years. Once it ends, repayment of both the principal and interest commences over 10 to 20 years. Since the interest rates are typically variable on HELOCs, your monthly payments will likely fluctuate over time.
Understanding Mortgage Payments
Before discussing the potential benefits and drawbacks of using a HELOC to pay off your mortgage, it’s worth understanding the specifics of mortgages and how payments work.
Types of Mortgages
There are three primary types of mortgages to be aware of:
- Fixed-rate mortgages: These home loan products are most common among homebuyers. You’ll get a fixed interest rate and predictable monthly payments (principal and interest) that remain the same for the life of the loan.
- Adjustable-rate mortgages: Also known as ARMs, they come with variable interest rates that change over time. You’ll get a lower interest rate to start for a set period, followed by a fluctuating rate that changes with market conditions.
- Second mortgages: As the name suggests, these mortgages are taken out alongside your current home loan, and your property is used as collateral. HELOCS and other home equity loan products fit into this category.
How Mortgage Interest Works
It varies by the type of mortgage. As previously mentioned, fixed-rate mortgages come with a set interest rate that doesn’t change during the repayment period. However, the rate on ARMs only remains the same during the initial period and changes after this window based on the index or benchmark interest rate.
Keep in mind that the loan term you select also plays an integral role in the total amount you pay in interest. A longer loan term could mean more affordable monthly payments, but it also gives the lender more time to collect interest from you. So, you’ll incur higher borrowing costs than you would if you opted for a shorter repayment period.
Mortgage Payment Structures
The monthly mortgage payments you’ll pay consist of two components:
- Principal: It is the total loan amount, or how much you borrow to purchase a home.
- Interest: It represents your borrowing costs and accounts for a larger portion of your monthly mortgage payments in the earlier part of the loan term.
You can also choose to roll property taxes, homeowners insurance and CDD fees into the monthly loan payments.
Some homeowners opt for interest-only loans. If this is an option, you’ll make interest-only payments for a set period to make the initial payments more affordable.
Advantages of Using a HELOC to Pay Off a Mortgage
Lower Interest Rates
HELOCs generally come with lower rates compared to traditional mortgages. So, you could potentially get more affordable monthly payments and save a bundle in interest over time.
Flexibility in Repayment
Unlike traditional mortgages, which have fixed principal and interest repayments, HELOCs offer a bit more flexibility. Most lenders let you make interest-only payments during the draw period, which could give you more wiggle room in your budget. You can also choose to pay over this amount to reduce the principal faster.
Access to Additional Funds
As previously mentioned, the amount of funding you can access through a HELOC depends on how much equity you have in your home. If it’s a sizable amount and your outstanding mortgage balance is on the lower end, you could end up with access to additional funds once you’ve repaid your home loan.
Risks and Considerations
Risk of Variable Interest Rates
HELOCs generally come with variable interest rates, which can be a significant downside since you’ll get unpredictable monthly payments. Unfortunately, your borrowing costs could be substantial over time.
Potential for Increased Debt
Paying off your current mortgage with a HELOC means swapping one debt for another. If the rate is better, you could lower your monthly debt payments through a HELOC. However, you could end up with an even greater debt load if market conditions change and the rate increases or if you use the HELOC funds to make other purchases.
Impact on Home Equity
When you take out a HELOC, the amount of equity you have in your home dips since you’re borrowing from it. This can be risky if you plan to sell soon and property values decrease, as your home will be underwater, and you could face trouble if the sale’s price isn’t enough to cover the outstanding mortgage and what you owe on the HELOC.
How to Use a HELOC to Pay Off a Mortgage
If you’re ready to apply for a HELOC to pay off your mortgage, here’s an overview of the lending guidelines, application process and a few tips to help you effectively manage your loan payments.
Eligibility and Qualification Criteria
You’ll typically need a credit score of 620 or higher and at least 15% in home equity. The lender will also assess your debt-to-income (DTI) ratio to determine if you can comfortably afford to take on a HELOC. Your DTI is the percentage of monthly gross income used to cover debt obligations, and it should be below 43% to have the best chance of qualifying for a HELOC.
Application Process
The application process begins with a search for the perfect lender. Shop around and compare interest rates, terms and fees offered by at least three lenders. It’s also worth getting pre-qualified to get a better idea of the loan terms you qualify for. Doing so also helps you narrow down your list of options.
Once you’ve selected a lender, formally apply for a HELOC and submit the required documents. Be sure to have your proof of income, including recent pay stubs and tax returns, along with bank statements handy. The lender will also ask a few key details about your home.
Be sure to review the loan application in its entirety before submitting it to confirm it’s free of errors or omissions. If the lender requests additional documentation, provide it promptly to avoid processing delays.
It could take a few days or even weeks to hear back from the lender, depending on demand and if they need more information from you. But if you’re approved, review the loan documents and ask any questions you may have before signing.
Budgeting for HELOC Payments
Remember, most HELOCs come with interest-only payments during the draw period. Depending on the principal balance, when the draw period ends, you can see a substantial increase in the monthly payments once the principal is added. Be sure to plan for the adjustment by creating wiggle room in your budget beforehand.
Creating a Repayment Strategy
It’s equally important to devise an effective repayment strategy for your HELOC. You must decide if you’ll pay off your mortgage at once or over time with a HELOC and how you’ll repay the funds you draw. By being strategic with your repayment strategy, you can effectively manage your HELOC and potentially avoid future financial challenges.
Alternatives to Using a HELOC to Pay Off Mortgage
Mortgage Refinancing
If you want to pay off your mortgage to get relief from hefty monthly payments, consider a mortgage refinance. You could potentially qualify for a lower interest rate or switch from an adjustable rate to a fixed-rate mortgage to make your monthly mortgage payments more manageable.
Personal Loans
A personal loan is also an option to pay off your mortgage if you’re able to borrow a large sum of cash. The rate you get is determined by your creditworthiness and financial profile, but it could be better than what you’d pay with a HELOC if you have excellent credit. Personal loans are also unsecured, so you don’t put your home at risk of foreclosure if you default on the loan payments.
Home Equity Loans
Like a HELOC, a home equity loan lets you convert your equity into cash. But you’ll get a lump sum of cash instead of a revolving line of credit to pull from. The interest rate is fixed, so payments are made in equal monthly installments over a set period. Keep in mind that home equity loans also act as second mortgages, so defaulting could mean foreclosure.
Loan Modification Programs
Inquire with your lender about loan modification programs if you’re having trouble managing your mortgage payments. You may qualify for a lower interest rate, extended loan term or alternative loan program.
When to Choose a HELOC to Pay Off Mortgage
A HELOC to pay off your mortgage could make financial sense if:
- You have a sizable amount of equity in your home and a low outstanding balance on your mortgage.
- The HELOC offers a lower interest rate than your current mortgage.
- You want the option to pay off your mortgage while still having access to a pool of funds to cover other expenses.
- You’ve consulted with a financial advisor to confirm this strategy aligns with your goals.
