Considering using a HELOC to pay off your mortgage? Learn about the risks and benefits of using a HELOC here.
A home equity line of credit, or HELOC, can be used by homeowners to free up home equity and accomplish all sorts of goals. It can help eliminate high-interest credit card debt, saving potentially thousands of dollars over a few years. A HELOC loan can help finance costly home improvement projects –– like replacing a roof, adding usable square footage, or creating a backyard oasis. And it can even help cover day-to-day expenses, for homeowners that just need a little extra cash. But did you know you could also use a HELOC to pay off your mortgage?
While this might not be the most common way to leverage funds from a home equity line of credit, it’s entirely possible. The question, then, becomes whether or not it’s worth it. Explore how homeowners can use a HELOC to pay off their mortgages (and some potential risks involved.)
Let’s first take a closer look at home equity. As you make payments toward your home loan and reduce your principal balance, your ownership share (your home equity) increases. For example, if you purchased your home for $400,000 and owe $100,000 on your loan, your home equity is 75%, or $300,000. Most homeowners won’t have access to this home equity until they sell their home, but even then, this equity is usually applied toward the sale of another home. But through financial tools like home equity loans, cash-out refinances, and HELOCs, homeowners can access this equity –– for a price.
In the case of a HELOC loan, this price comes in the form of interest. When you take out a HELOC, you’re taking out a loan against your home equity, with your available equity determining how much you can borrow. Most lenders will cap this amount at 80% of your home equity, or $240,000 using the above scenario.1 As you draw from this available credit, you begin making monthly home equity loan interest payments which last for the duration of the draw period –– lasting anywhere from 5 to 10 years.2 After this period ends, you’re responsible for both interest and principal payments, which can send your monthly payments soaring if you’ve done quite a bit of dipping into your available equity.
See related: HELOC vs. Refinance
The short answer? Yes. But your specific financial circumstances may prevent you from using a HELOC to access your home equity and pay off your mortgage. To qualify for a HELOC, you must meet a number of requirements: including credit score parameters, debt-to-income limitations, and home equity ownership stipulations. If your credit score is above 620, your debt-to-income ratio is below 40%, and you own 15% or more of your home, you may be able to qualify for a home equity line of credit and be on your way toward using it to pay off your mortgage. (Note: these figures are approximations, and approval will vary from lender to lender.)
But if I pay off my home using my equity, will I still owe on my home? The answer here is also yes, but instead of owing on your mortgage, you now owe on the HELOC used to tap into your equity. There are a few reasons why you might consider this option, including:
If your circumstances don’t quite match the above, you may still be able to benefit from this approach –– but do your due diligence to make sure this move is right for you.
You know the “what” and the “why” of using a HELOC to pay off your mortgage. Now it’s on to the “how.” Below is a step-by-step look at how this strategy could be executed, should you decide this pathway is right for you.
Before making the choice to use a home equity line of credit to pay off your mortgage and crafting your subsequent strategy, it is crucial to thoroughly understand your financial situation. Start by evaluating your existing mortgage terms, including your outstanding balance, interest rates, and any prepayment penalties or fees associated with your existing mortgage. Then assess your income, expenses, and overall budget to determine if utilizing a HELOC aligns with your long-term financial goals.
Lastly, determine why exactly you’re hoping to pay off your mortgage using a HELOC. Is it to get a better or lower interest rate? Are you hoping to use some of your available equity toward other expenses –– like home improvement, repairs, or renovations? The better you know your situation, the more informed your future decisions will be.
With your goals clearly defined, you can begin to research and compare different financial institutions to find the best interest rates and terms for your HELOC. Many large banks stopped accepting applications for HELOCs during COVID-19, including Chase, Wells Fargo, and Citi, so you may have to look for lenders outside of your personal banking provider if you’re a customer of one of these three.3
When you shop for a home equity line of credit, look for lenders that offer competitive interest rates, low or no fees, and flexible repayment options. Also, be sure to consider factors like whether your interest rate is adjustable or fixed, how long your draw period will be, and what your repayment period will look like. These factors can have a huge impact, and when overlooked can do more harm than good. Once you’ve found the right HELOC for you, carefully review the terms and conditions, seeking clarification from the lender on any points that are at all unclear.
Once you have identified a suitable lender and the right rate, you can begin the HELOC application process. This process is similar to applying for a mortgage, meaning you’ll have to provide all necessary documentation –– including proof of income and credit history –– to be considered. You’ll also have to provide mortgage information for both proof of ownership and home equity information. While this process is fairly smooth for many homeowners, you should be prepared to answer any questions the lender may have regarding your financial situation and make sure your application is both accurate and complete to avoid any hiccups.
Upon approval of your HELOC –– which can take anywhere from a few days to a few weeks –– you can start utilizing the funds to pay off your mortgage. If you plan to put your entire available line of credit toward your mortgage, you’ll want to work closely with your lender to ensure a smooth transfer of funds to your mortgage account. If you plan to divide your available funds between paying off your mortgage and tackling other expenses like credit card debt, be sure that your funds are being deposited in your chosen bank account instead, giving you the freedom to eliminate debt and cover expenses however you please.
Once you’ve put your HELOC to use, you arrive at what is perhaps the most crucial step: making regular, on-time payments toward your HELOC. You can set up automatic payments or establish a budgeting system to ensure timely repayment –– and set calendar reminders to stay on top of important dates (like the end of your draw period and the beginning of repayment.)
Making consistent, on-time payments will help you maintain a good credit score while avoiding any penalties or fees associated with late payments. Further, it will help you limit the amount of interest you’re accruing, preventing this financial strategy from becoming a flat-out liability.
As we mentioned above, making your monthly HELOC payments on time is crucial in terms of mitigating the risks of a HELOC. During the draw period, when these monthly payments are a fraction of what they can soon become, this may be no big deal. But when this draw period ends and repayment is owed on both the loan’s principal and its interest, many homeowners may find themselves in a bit too deep. So, the importance of anticipating your full monthly payment –– that is, what you’ll owe after the draw period comes to an end –– is crucial.
For the sake of this example, let’s say a homeowner has $50,000 left on their mortgage and $200,000 in home equity. With an excellent credit score and an average interest rate of 8.45% at the time of writing, the monthly, interest-only payment would be just over $350 for a 10-year HELOC.4
Factor in the payment owed on the principal amount, however, and this monthly payment can nearly double, jumping to over $600 during the 10-year repayment period. If this inflated monthly payment doesn’t bother you, consider the fact that this $50,000 chunk of equity has now incurred over $22,000 in interest. If this is $22,000 you’d rather not owe when all is said in done, consider paying off your HELOC early (or opting for a different means of paying off your mortgage.)
Depending on your situation, using a HELOC to pay off your mortgage can either be the best idea or the worst one –– and where you fall on this spectrum will come down to your finances and goals. However, hefty interest fees, unpredictable variable interest rates, and confusing repayment periods can mean this financial tool just isn’t worth the risk for many homeowners. Fortunately, there are several alternatives –– like home equity loans and refinancing options –– which allow homeowners to accomplish their financial goals.
Truehold’s sale-leaseback was created for these exact homeowners: offering them the ability to tap into home equity without being on the hook for thousands of dollars in interest charges. Sell your home to Truehold in exchange for your home equity, then continue to live in the home while paying rent or move out and onto greener pastures. With this equity, you can buy another property, take a much-needed vacation, or invest in your future. The choice is yours!
Want to learn more? Reach out to one of our advisors today.
Sources:
1. Forbes. How Much HELOC Money Can I Borrow? https://www.forbes.com/advisor/home-equity/how-much-money-can-you-borrow-with-a-heloc/
2. Bankrate. What is the draw period on a HELOC and how does it work? https://www.bankrate.com/home-equity/heloc-refinance-draw-period-ends/
3. Bankrate. How does the coronavirus crisis affect HELOCs? https://www.bankrate.com/home-equity/coronavirus-impacting-helocs/
4. US Bank. Home Equity Rate and Payment Calculator. https://www.usbank.com/home-loans/home-equity/home-equity-rate-and-payment-calculator.html
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