Despite changes in the housing market, many borrowers today have significant equity in their homes. If you’re one of them, you might be wondering if it makes sense to use a home equity line of credit to pay off your mortgage, especially if you don’t owe a lot on your home. Here’s what to know about paying off your mortgage with a HELOC and the risks involved.
Can a HELOC help you pay off your mortgage?
It is possible to use funds from a HELOC to help pay off your mortgage. If you have a lot of equity in your home and don’t have much left to pay on your loan, you might even be able to pay it off completely with the line of credit.
HELOCs work by allowing you to leverage the equity in your home to obtain funds for any objective or purpose, such as home improvements, tuition, or even emergencies. Depending on your capital level, you will be approved for a certain amount, which you can borrow in whole or in part during the HELOC drawdown period, usually 10 years. During this time, you will pay interest on what you borrow, at a variable rate. After the drawdown period, you’ll have to repay what you borrowed (with any interest due), usually over a 20-year period.
Advantages and Disadvantages of Using a HELOC to Pay Off a Mortgage
Advantages
- Possibility of a lower rate: If your current mortgage has a higher interest rate and the HELOC has a lower rate, you can use HELOC funds to pay off your mortgage sooner at a lower cost. Much depends on the broader mortgage market, however – right now, rates are rising on all types of loans, including HELOCs. Compare current HELOC rates.
- Flexibility: HELOCs are a more flexible form of financing in that you can only borrow what you need out of the total amount you have been approved for. For example, if you don’t want to use all of the HELOC funds to pay off your mortgage, you can decide to spend some of the money on home renovations or other expenses, or not to borrow it at all.
- Low or no closing costs: Although HELOC closing costs typically range from 2% to 5% of the amount you borrow (similar to a mortgage), the expense may be less than a cash refinance because you’re likely borrowing less. Some lenders even offer HELOCs with no closing costs.
The inconvenients
- Floating rate: HELOCs come with a variable interest rate, which means your rate will fluctuate over time depending on market conditions. There’s no way to predict whether your rate will go up or down in the future, so you’ll need to be prepared to build higher payments into your budget.
- More debt: Although the HELOC could pay off your mortgage, you would also replace that debt with another form of debt, and you could end up paying more interest than you would on your current mortgage. This affects your credit score and your finances, especially if it doesn’t help you save money in the long run.
- Fees and penalties: Many HELOCs have annual fees, and some come with a prepayment penalty if you pay them off earlier than the repayment schedule requires.
- Flexibility: The flexibility of a HELOC can also be a disadvantage in that it can cause you to spend the funds impulsively or overextend yourself financially.
Example of using a HELOC to pay off a mortgage
Let’s say 20 years ago you took out a $300,000 30-year mortgage with a rate of 6.5%. Today, your remaining balance is $164,107 and your home is currently worth $675,000. This means you have $510,893 in equity. You would only need to borrow about 30% of that amount with a HELOC to pay off your mortgage balance.
Is it a good idea to pay off the mortgage early with a HELOC?
Although you can use a HELOC to help pay your mortgage, it has limitations. HELOC lenders typically only allow you to borrow up to 80% (sometimes 85%) of the value of your home as a line of credit. Depending on your specific finances, this might not be enough to fully pay off your mortgage.
Whatever funds you use from the HELOC must also be repaid, usually over a repayment period of up to 20 years. If you’re about to pay off your current mortgage, you may not want to commit to paying off another debt over several years, especially if you’re nearing or in retirement and on a fixed income.
The variable rate is also reason enough to take a break. The Federal Reserve has indicated its intention to continue raising its key rate in 2022, which means higher rates on HELOCs.
“Floating-rate HELOC customers could easily see their interest rates increase significantly,” says Herman (Tommy) Thompson, Jr., CFP, of Innovative Financial Group in Atlanta. “It’s also unlikely that the interest rate on a HELOC in 2022 will actually be lower than on a mortgage acquired within the last 20 years.”
Other Ways to Pay Off or Prepay Your Mortgage
If your goal is to pay off your mortgage early, you might be better off making extra payments, if possible, or, as an alternative, taking out a home equity loan. When making additional payments, you can choose to pay an additional lump sum or start making payments every two weeks. With a home equity loan, you’ll get a fixed rate (as opposed to a variable rate with a HELOC), which means your monthly payments won’t change. However, you are still borrowing money to repay the borrowed money, which is not ideal. Consider this and a HELOC carefully if you’re looking to get rid of your mortgage sooner.
