Should you pay off your mortgage with a HELOC?
A home equity line of credit (HELOC) can be an attractive option for homeowners who want to access a flexible, low-cost line of credit.
Some homeowners use HELOCs to cover financial emergencies and big-ticket items; others consolidate debt to make the balances more manageable. But what about using a HELOC to pay off your mortgage faster and enjoy lower monthly payments? Is it a good idea? Read on to learn the pros and cons of using a HELOC to pay off your mortgage as well as alternatives.
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A HELOC works like a credit card. It's a revolving line of credit that lets you borrow against your home equity, which is the difference between what your home is currently worth and how much you owe on your mortgage. You can pull funds during what's referred to as the draw period — it typically lasts up to ten years.
Most lenders only require interest-only payments while the line is open. The interest rate is variable, though, so the monthly payments fluctuate. Once the draw period ends, payments increase to reflect both principal and interest.
Learn more: How do fixed-rate HELOCs work, and which lenders offer them?
While most homeowners commonly use HELOCs for big-ticket expenses and debt consolidation, some use HELOCs to repay their mortgages early.
Flexibility: You can withdraw funds as needed and use them however you see fit.
Controlled costs: You only pay interest on the funds you withdraw, giving you more control over borrowing costs.
Competitive rates: You may get a lower rate than you would with other refinance options, or, in some instances, a traditional mortgage.
Interest-only payments: Only paying interest during the draw period makes HELOC payments more affordable.
Minimal closing cost: You can expect minimal closing costs on HELOCs.
Variable rates: Most HELOCs come with variable interest rates, so monthly payments fluctuate during the draw and repayment periods.
Prepayment penalties: Some lenders assess prepayment penalties if you pay a HELOC off early.
Fees: Some lenders charge origination fees, annual fees, and dormancy fees on HELOCs.
Risk of foreclosure: A HELOC is secured by your home, so you could lose it to foreclosure if you default on the payments.
Learn more: What to expect when facing foreclosure
If you choose to pay off your mortgage with a HELOC, keep these general guidelines in mind:
Equity: You should have at least 15% to 20% in home equity. More equity could mean access to a larger HELOC.
Credit score: Most lenders prefer a credit score of 680 or higher; 700 is even better. A strong credit score also helps you access more competitive rates.
Income: Lenders want reassurance that you can afford to repay the HELOC. So, consistent, verifiable income is required to qualify.
Debt-to-income (DTI) ratio: This is the percentage of monthly income spent on debt obligations. Aim for a DTI ratio below 43%.
Insurance: Lenders generally require proof of homeowners insurance.
Research several lenders and create a shortlist of those you may want to do business with. Get prequalified with at least three lenders and compare quotes to find the best fit. The amount you qualify for should be enough to pay off your mortgage balance.
Read more: Best HELOC lenders
Gather the required information and documentation. Once you've done so, formally apply with your chosen lender.
The timeline from application to closing varies by lender. Upon approval, funds are generally deposited electronically into your bank account.
Initiate a HELOC withdrawal to cover your home loan's outstanding balance. Pay your lender directly to satisfy your mortgage debt and begin making HELOC payments as they come due.
Your mortgage balance is low.
You want lower long-term housing costs.
You want to shift your focus to other financial goals.
You can qualify for a better rate than you currently have.
You want to stop paying mortgage insurance.
You plan to move soon.
You're almost to the end of your mortgage term.
Your lender assesses hefty prepayment penalties.
You don't plan to relocate in the foreseeable future.
You have a much lower rate with your current mortgage.
A mortgage refinance lets you swap out your current loan with a new one, preferably with a lower interest rate and shorter term. Or you can opt for a cash-out refinance. Like a traditional refinance, it lets you swap out your current mortgage. But the new home loan is larger and includes any equity you've built up. You'll receive the difference between the new loan and what you owe in cash.
Similar to a HELOC, you can borrow against your home equity with this option. But there are a few key differences between the two. With a home equity loan, you receive a lump sum and are responsible for paying interest on the entire amount. Home equity loans also come with fixed interest rates, and you can expect closing costs.
A mortgage recast is also an option if you're sitting on a large sum of cash. You'd make a large payment toward the principal and ask the lender to re-amortize the remaining balance. The end result: lower monthly mortgage payments without modifying your loan terms. This service comes at a cost, though.
Considering paying your mortgage off early but not right away? Paying extra each month could be more viable and cost-efficient. You could double up if there's room in your spending plan or pay whatever extra you can each month. Biweekly payments are also smart, as they equal an extra monthly payment annually.
If you're at least 62, you can use a reverse mortgage to wipe away home loan debt. It pays off your mortgage, and you receive the equity in a lump sum, monthly installments, or as a line of credit. But you don't have to make payments to the lender. Instead, ownership of the home transfers to the lender if you decide to sell, relocate, or pass away. That's unless the balance, including any accrued interest, is paid in full.
Learn more: HELOC vs. reverse mortgage vs. home equity loan — which one is best?
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Can you use a HELOC for a down payment?
If you have enough equity in your home, you may be able to tap into it using a home equity line of credit, or HELOC. Before using a HELOC for a down payment on a second home or investment property, it's essential to know how it works, its benefits, and the associated risks. This embedded content is not available in your region. Homeowners can use the equity from their primary residences for a down payment on a vacation home or investment property. However, you'll need sufficient equity to qualify. A home's equity is its value minus the outstanding mortgage. For example, if a property appraises for $500,000, and the outstanding mortgage balance is $300,000, the equity is $200,000, or 40%. When determining your eligibility, lenders will consider your equity, credit score, debt-to-income (DTI) ratio, and income. Here are some of the typical HELOC requirements you can expect. Enough home equity: Homeowners typically need 15% to 20% equity in their home to meet lender requirements. Good credit score: Many lenders want a minimum credit score of 680, but the higher the better. Low DTI: Ideally, a DTI of 45% or lower signals to lenders that you can manage your debt. Sufficient income: Stable income and employment communicate to lenders that you can repay the HELOC balance. A HELOC is a line of credit that works like a credit card. When buying a second home, you can use HELOC funds for the down payment, closing costs, or other expenses up to your approved credit limit. You usually have 10 years to withdraw from your HELOC. During this period, you're typically only required to make interest-only payments. Once the draw period ends, you can no longer access your line of credit. In the repayment period, you'll make full interest and principal payments until the balance is paid off, typically over 20 years. If you need to borrow money to come up with cash for a down payment, HELOCs can be more affordable than other loans or lines of credit. Here are a few of their advantages. Potentially lower interest rates: HELOC rates are typically lower than those for credit cards and personal loans, allowing you to borrow money for less. Access funds as needed: You can withdraw from the HELOC as often as needed during the draw period. Lower payments up-front: Lenders usually require interest-only payments during the draw period, which can be much lower than the minimum payments for other loans. May be tax-deductible: You may be able to deduct HELOC interest if you use the money to purchase a second home, but you'll have to meet other IRS guidelines. A home equity line of credit can be risky, primarily because your home is collateral. Here are a few of the disadvantages to consider. Variable interest rate: Most HELOCs have variable interest rates that fluctuate depending on the economy. Payments on variable-rate loans can be harder to predict or plan for. May require closing costs: Lenders may charge closing costs that cover originating, underwriting, and processing the loan. HELOCs can also have additional charges, like account management fees or early cancellation penalties. Easier to overspend: You may be tempted to use your credit line for more than you need to, especially if you only make the minimum interest-only payments. Default risks foreclosure: Your home is collateral for a HELOC. So, if you have trouble repaying the balance, the lender can foreclose on your home. Borrowing from your home's equity to buy a second home could make sense, but only if you can withstand the financial risk. 'There's a compounded risk of increased rates and a strained cash flow, so a HELOC is best for well-income homeowners, with healthy reserves, and a plan to refinance or pay it off early — ideally within 12 to 24 months,' said Randall Yates, investment specialist at VA Loan Network, via email. 'Where it doesn't work is if you live on a tight budget, especially when rates are volatile, or you're buying a property that already pushes your DTI limits.' Consider these alternatives if using a HELOC for a down payment isn't right for you. Home equity loan: Access your home's equity in a lump sum, typically repaid at a fixed interest rate. Bridge home equity loans delay repayment until you sell the home. Cash-out refinance: Refinance your current home loan, borrowing the existing mortgage balance plus cash from your equity that you can use toward a down payment on a second home. Personal loan: Most personal loans are unsecured, meaning you can borrow a lump sum and repay over a fixed period without collateral. You can use a HELOC to make a down payment on a second home or investment property. You'll likely need 15% to 20% equity and meet other borrower requirements, like a good credit score, low DTI, and stable income. HELOCs are lines of credit, allowing you to access your home equity for the down payment and fees, up to your approved credit limit. You usually have 10 years to access your HELOC funds. During this draw period, you can make interest-only payments. Once you're in repayment, you'll make principal and interest payments until the balance is paid off. A HELOC could be a suitable option for homeowners with significant equity in their primary residence. With lower rates than personal loans and interest-only payments up-front, a HELOC is often a more affordable way to borrow, but only if you can keep up with the payments. If you're unable to repay the HELOC, you could lose your primary residence.
