Most people view a home equity line of credit (HELOC) as a way to consolidate debt, fund home improvements, or serve as an emergency fund. But did you know that you can also use a HELOC to eliminate your primary mortgage?
We’ll go over the pros and cons of using a HELOC to pay off your mortgage, what types of homeowners may best benefit from this strategy, and talk about a few alternatives you might want to consider instead.
Key Takeaways
- HELOCs can often be used to pay off an existing mortgage, but doing so won’t be beneficial for everyone.
- Financially stable homeowners currently locked into a high interest rate and a long remaining loan term are most likely to benefit from paying off their mortgage with a HELOC.
- Borrowers with marginal credit and a high level of existing debt may be better off sticking with their existing loan or refinancing traditionally.
What Is a HELOC and How Does It Work?
A HELOC is a revolving line of credit, secured by your built-up home equity, that functions much like a credit card. You can use a HELOC to borrow against your equity, repay the borrowed funds (although you aren’t required to until later on in the loan), and then use your available credit again as many times as you’d like.
HELOCs are split into two distinct phases:
- Draw Period: During the draw period, you’ll have unfettered access to your line of credit. In this initial phase of the loan, you are only required to make monthly interest payments on the portion of your equity you’ve used up to that point. This period typically lasts from 5 to 10 years, with some lenders even offering HELOCs with 15-year draws.
- Repayment Period: The repayment period follows the draw period. During this phase of the loan, you will no longer be able to use your line of credit and will need to make monthly principal and interest payments on the balance of your loan. Repayment periods commonly last from 10 to 20 years.
Unlike most traditional mortgages, which have fixed interest rates, HELOCs typically feature variable rates that can fluctuate over time in response to changes in overall market conditions. In most cases, these lines of credit function as second mortgages, meaning they sit alongside your existing loan rather than replace it.
Using a HELOC to Pay Off Your Mortgage
For some homeowners, though, a HELOC can be a practical way to satisfy their current mortgage – either by paying off a portion of the balance or the entire balance. Technically, however, this isn’t truly paying off the mortgage but rather refinancing it into a different, more flexible type of loan.
Some of the reasons why borrowers may want to use a HELOC to pay off their current home loan include:
- Initial interest-only payments can lower monthly costs and free up cash flow
- The excess line of credit can be used for other purposes – such as funding home repairs – without carrying two separate loans
- In decreasing interest rate environments, a HELOC may lead to lower costs as rates change in accordance with market conditions
Example: Paying Down a Portion of Your Principal
Let’s take a quick look at how paying down a portion of a current loan balance with a HELOC could work out in a real-world example scenario:
Richard and Mary own a home valued at $350,000, which they purchased three years ago. They originally borrowed $200,000 at a 7% interest rate and currently owe $195,000. Their existing monthly payment is $1,331.
The couple applies for an 85% LTV HELOC at 7.5%. With their existing loan balance, they are approved for a line of credit of $102,500 and plan to use $100,000 to pay down their mortgage.
Since they’re not paying off their primary loan, their payments would normally stay the same. However, they ask their lender to recast their mortgage to lower its monthly cost. Their $95,000 balance is amortized over the remaining 27 years of their loan with new payments of $653.
Since Richard and Mary are in the interest-only stage of their HELOC, their payments are $625, for a combined monthly mortgage of $1,278. Overall, they’re saving $53 per month and plan to sell their home and satisfy both loans before their 10-year HELOC draw period ends.
Here, with closing costs and potential annual fees associated with a HELOC, this strategy may not be beneficial enough to make sense.
Example: Paying Off Your Mortgage Completely
Now, let’s see what might happen if you were to choose to pay off your existing mortgage in full with a HELOC:
Jessica owns a home valued at $600,000 that she previously owned outright until three years ago, when she did a cash-out refinance for $250,000 at an interest rate of 7.5%. Her monthly payments are currently $1,748.
She aims to get a HELOC – also at 7.5% – for her remaining $240,000 balance. This would equate to monthly interest-only payments of $1,500.
In this scenario, Jessica is saving $248 per month. She anticipates interest rates dropping in the future and plans to refinance her HELOC back into a conventional loan before it enters the repayment period.
How to Do It
So, how do you use a HELOC to pay off a mortgage? Here are the five key steps you’ll encounter.
1. Check Your Eligibility
Qualifying for a HELOC is much like qualifying for any other type of mortgage. Requirements, however, tend to be a bit more stringent than for a typical home loan.
Generally speaking, the three most important things to consider are your:
- Credit Score: HELOC lenders typically look for a minimum score of 680 or higher. Conventional purchase and refinance loans, on the other hand, often require a 620 credit score.
- Home Equity: You’ll need at least 20% equity to access a line of credit. If you plan to pay down or off your primary mortgage, you’ll need far more.
- Debt-to-Income Ratio: Most HELOCs require you to have a debt-to-income ratio no higher than 43%.
2. Determine Your Borrowing Limit
Most lenders offer HELOCs for up to 80% to 90% of your home’s current appraised value, minus what you still owe on your existing loan.
For example, if you have a home worth $350,000, owe $100,000 on your current loan, and are applying for a 90% LTV HELOC, your maximum borrowing limit would be $215,000.
Keep in mind, though, that this doesn’t inherently qualify you for this large a line of credit. Other factors, such as your debt-to-income ratio, can still affect this figure.
3. Compare HELOC Offers
HELOC offers can vary drastically from one lender to the next. To help ensure you’re receiving the best deal possible, shop around with at least three different mortgage providers and keep in mind:
- Interest rates
- Ongoing and situational fees
- Draw/repayment period lengths
- Closing costs
4. Apply and Get Approved for a HELOC
After choosing the lender you want to work with, the next step is to formally apply for the HELOC and undergo the loan underwriting process. This typically involves obtaining a professional home appraisal; however, some companies may use an automated valuation model to determine the property’s value.
Once you’ve been approved for the HELOC and have access to your line of credit, you can then withdraw the funds to pay down or off your current mortgage balance.
5. Manage Your HELOC Payments
At this point, you’ll be responsible for making regular monthly payments on your HELOC. During the draw period, these will just be for the interest on your balance – although you can pay extra towards your principal if you choose.
During the repayment period, however, you’ll need to cover both principal and interest costs, so be sure to plan for the jump in payments – or to refinance – by the time the draw phase is winding down.
Advantages of Paying Off Your Mortgage With a HELOC
We’ve already covered a few of the reasons why someone might want to use a HELOC to pay off their mortgage, but let’s revisit them and go over some more potential advantages:
- Lower interest-only payments during the draw period can free up cash flow and provide a little breathing room in your monthly budget.
- HELOCs provide you with the flexibility to borrow only what you need, when you need it. You can pay off your mortgage and then use the funds for other purposes – like home improvements or debt consolidation – later on if you choose.
- Since HELOCs aren’t initially amortized like traditional loans, some homeowners may be able to keep making payments at their current amount and pay off their mortgage faster.
- HELOC closing costs may be lower than refinance closing costs. Some lenders may even waive closing costs altogether.
- If overall interest rates decrease in the future, adjustable-rate HELOCs could potentially wind up being cheaper than if you stuck with a fixed-rate traditional loan.
Disadvantages and Risks to Consider
Despite the potential benefits, there are plenty of disadvantages and risks to consider before using a HELOC to pay off your mortgage, including:
- You aren’t technically paying off your mortgage – you’re just transferring it. At the end of the day, you’ll still owe the same amount.
- If overall interest rates rise, you could wind up with larger monthly payments than you initially expected, and wind up paying far more than with your current loan.
- Many HELOCs entice borrowers with low introductory rates for the first 6 to 12 months; the rate after this period could significantly increase costs.
- The interest-only draw period typically lasts for 5 to 10 years, meaning you need to proactively plan for how you’ll manage the payments once you’re required to cover the principal balance as well.
- While closing costs could be cheaper than a traditional refinance, you’ll often still be on the hook for between 2% to 5% of your available credit. Lenders who waive these fees will likely charge higher rates and include prepayment penalties.
- Borrowers who itemize their income tax deductions can deduct the interest they pay on a traditional home loan. HELOCs do not provide this benefit, except for funds used to make significant improvements or repairs.
- HELOCs are still secured by your home. If you are unable to make payments at any time, such as when rates rise or the repayment period begins, the lender could foreclose on your property.
Who Should Consider This Strategy?
You may want to consider paying off your mortgage with a HELOC if:
- You have a strong credit score, a stable and secure income, and a high level of equity
- You’re confident enough in your finances that you can comfortably make larger payments if interest rates rise
- You have plans to utilize your line of credit for other purposes that improve your overall financial situation, such as debt consolidation or funding a new business
- You are disciplined enough to avoid overspending your excess available funds
Who Should Avoid It?
While using a HELOC to pay off your mortgage makes sense in some scenarios, it may not always be the best option. Here are some types of borrowers who should probably avoid this strategy:
- Homeowners with marginal credit, a high debt-to-income ratio, and low existing equity
- Anyone with mortgages secured at ultra-low fixed rates, such as those seen prior to late 2022
- Borrowers whose existing loan is nearly paid off, and the majority of their payments are already going towards the principal
- People who aren’t financially secure enough to cover potentially increasing variable-rate payments or manage transitioning into the repayment period
- risk-averse individuals who would feel more comfortable with the predictability of consistent fixed-rate payments
Alternatives to Using a HELOC
Before deciding to use a HELOC to pay off your current mortgage, here are some other alternatives that you might want to consider instead:
- Making additional payments towards the principal balance on your current mortgage to pay off the loan sooner.
- Refinancing your existing mortgage through a rate-and-term or cash-out refinance for lower interest rates, more favorable terms, and tax advantages.
- A home equity loan – another type of second mortgage – can be used for the same purpose but comes with a fixed rate and predictable monthly payments.
- Consulting a financial advisor or credit counselor who can help you develop a personalized strategy for meeting your financial goals.
Final Thoughts & Key Considerations
In some scenarios, using a HELOC to pay off your mortgage can make sense, especially when you plan to use your line of credit for other purposes and are comfortable with the potential risks of a variable-rate loan.
However, not all homeowners will benefit from this strategy, particularly those with moderate credit and high existing debts, or those who are currently locked into highly favorable below-market interest rates.
Before choosing whether you want to use a HELOC to pay off your existing mortgage, make sure to consult both financial and tax professionals and talk with an experienced loan officer for a detailed comparison of the costs and total interest you’ll pay with each plan.
