HELOC (home equity line of credit) can be used to fund a home renovation, consolidate very high interest cards, or for any other purposes. Do you know the fun part? You can even use HELOC to pay off your mortgage.
However, you need to know that, based on the new HELOC and your mortgage terms, this process may not be the right step. Before you go through this process, it is advisable that you understand how it works and the drawbacks involved. In this article is everything you need to know about how to use a HELOC to pay off your mortgage.
What is HELOC?
A Home Equity Line of Credit (HELOC) is a type of loan designed to make use of your home equity as collateral. Unlike a home equity loan, which gives you a one-time lump sum, a HELOC is designed more like a credit card. It offers a pool of funds you can tap into as needed, borrowing as much or as little as you like. You’re only required to repay the amount you made use of.
Home Equity Line of Credit is very versatile, and you can make use of them for various purposes. This includes consolidating high-interest debt like credit cards to cover college expenses, funding home renovations, investing in rental properties, or even paying off your current mortgage.
Can You Pay Off Your Mortgage Using Your HELOC?
Just as I have mentioned above, you can pay off your mortgage with a Home Equity Line of Credit. However, this is a strategy that works best in certain cases.
You need enough equity in your home; most lenders require at least 20% to qualify for a HELOC. If you do, you can easily make use of the money you get to reduce your mortgage balance significantly or remove it completely.
Why You Might Consider Using a HELOC to Pay Off Your Mortgage
Making use of HELOC to pay off your mortgage could be appealing if you’re looking to lower your interest rate. And this can help lead to reduced monthly payments and significant savings. However, it’s important to remember that HELOC rates are usually higher than mortgage rates and often variable, meaning they can increase over time, making this process quite a hard strategy.
An interest-only HELOC offers you very low initial payments, as you only pay the interest during the draw period. And this is mostly in the first 10 years. These payments might be lower than your current mortgage payments, depending on how much you borrow and the rates at the time. Once the draw period ends, you’ll start repaying the principal, with the repayment period typically lasting up to 20 years.
Another advantage is that using a Home Equity Line of Credit to pay off your mortgage can be more cost-effective than refinancing. Since this process generally has lower closing costs, and some lenders might even waive them.
When You Should Not Consider It
It is advisable that you avoid using a Home Equity Line of Credit to pay off your mortgage if the math doesn’t add up. Specifically, you should avoid it if the interest rate on the HELOC is more than your current mortgage rate. Even if the HELOC rate is lower now, the variable nature of HELOCs could lead to higher interest costs over time.
You should also keep taxes in mind. Another factor is how far along you are in your mortgage. If you’re mostly paying off the principal now, it may not make sense to switch to HELOC and start paying more interest again.
How to Use Your HELOC to Pay Off Your Mortgage
Here’s a step-by-step guide to using your home equity to reduce or eliminate your mortgage:
- Compare lenders: Shop around to find the best rates and terms. Look for a lender that charges fewer upfront fees or offers to waive some closing costs.
- Apply for a HELOC: The application process is a very simple one and less expensive than refinancing. Your loan limit will depend on how much equity you have in your home.
- Get a Home Appraisal: An appraisal is very important to determining your home’s equity. Some lenders may offer a virtual appraisal, which can lower your underwriting costs.
- Close the loan: Sign the closing documents, which outline your interest rate, fees, and the terms of your draw and repayment periods. You can usually access your funds on the fourth business day after closing.
- Pay off Your Mortgage: Withdraw the necessary amount from your HELOC to pay off your mortgage balance and send the payment to your mortgage servicer.
- Make HELOC Interest Payments: During the draw period, you may only need to pay interest, but paying down the principal can save you on interest over time.
- Repay the Principal: Once the draw period ends, you will need to start making principal and interest payments. The repayment period typically is about 10 to 20 years.
- Plan for Variable Interest Rates: Most HELOCs have variable rates that can change over time. Some lenders offer fixed rates, and these start higher but protect you from future rate increases.
If rates drop in the future, consider refinancing your Home Equity Line of Credit to lower costs or improve your repayment terms.
Pros of Using a HELOC to Pay Off Your Mortgage
- Lower Monthly Payments: During the initial draw phase, you might only need to pay the interest, freeing up cash for other expenses. Plus, there’s usually no penalty for paying off the principal early.
- Lower Closing Costs: HELOCs typically come with fewer closing costs than mortgage refinance, which can save you money upfront.
- Flexible Withdrawals: You can tap into your home equity for other needs, like consolidating high-interest debt or making tax-deductible home improvements.
Cons of Using a HELOC to Pay Off Your Mortgage
- Variable Interest Rates: Most HELOCs have variable rates that can change often. If rates rise, your monthly payments and total costs will increase. There’s also no guarantee that your HELOC rate will be lower than your current mortgage rate.
- Equity Requirements: Many lenders require you to have at least 15% to 20% equity in your home to qualify for a HELOC.
- Risk to Your Home: Your home serves as collateral for the HELOC, just like with your primary mortgage. If you do not pay back, the lender could foreclose on your property.
Alternatives to Using a HELOC to Pay Off Your Mortgage
A HELOC might not always be the best choice for paying off your mortgage. You should consider going for other options, such as;
- Extra Mortgage Payments: Simply staying with your current mortgage and making extra payments might be the easiest and most effective route. You could switch to biweekly or pay the equivalent of 15-year mortgage payments. Each additional payment reduces your principal and cuts down on lifetime interest without needing to apply for a new loan.
- Home Equity Loan: This option lets you use your home’s equity by giving you a lump sum, which you can apply directly to your mortgage balance. With a home equity loan, you get a fixed interest rate and predictable monthly payments, making it easier to manage your budget and potential interest savings.
- Mortgage Recast: Recasting your mortgage involves making a large payment toward your principal. While your interest rate and loan term remain the same, you’ll pay a small fee (usually a few hundred dollars) and enjoy lower monthly payments for the rest of your mortgage term.
- Mortgage Refinance: Refinancing your mortgage is a more traditional way to secure a lower interest rate and could be more cost-effective than a HELOC. When you refinance, you replace your current mortgage with a new one at a better rate and term.
Bottom Line
A HELOC can be very important and useful financial tool for goals like consolidating debt, including paying off your mortgage. By doing this, you are making use of the equity in your home to clear your debt. However, this leaves you with HELOC debt to repay and manage.
Always keep in mind that this approach only makes sense if the HELOC interest rate is significantly lower than your current mortgage rate. But with today’s higher HELOC rates, the costs might outweigh the benefits. This makes it a wiser decision to hold off on this strategy at the moment.
