Should You Use a HELOC to Pay Off Your Mortgage?

Do you have a substantial amount of equity built up in your home? If your home’s value has also increased, you could take out a home equity loan or home equity line of credit (HELOC) to pay off your mortgage and possibly save a bundle in interest. But is borrowing against your home a good idea, and if you have to choose, which option is best?

Keep reading to learn more about how they work and the benefits and drawbacks of each. Understanding the pros and cons can help you make a better choice based on your financial situation and how much equity you have in your home.

What Is a Home Equity Line of Credit (HELOC)

A HELOC also acts as a second mortgage and lets you access your home’s equity. It is a revolving line of credit that increases your mortgage debt. Homeowners can use HELOC funds in any way they desire.

How Do HELOCs Work?

Most lenders allow you to borrow up to 85 percent of your home’s equity minus the outstanding mortgage balance. So, if your home is worth $435,000 and you owe $165,000 on the mortgage, you could qualify for a HELOC up to $204,750 ($435,000 * .85 – $165,000).

But instead of receiving the loan proceeds in a lump sum, you’ll get access to a line of credit. You can make withdrawals from this pool of cash at any time during the draw period, which is typically ten years. The lender will likely assess interest-only payments during the draw period as well.

When the draw period ends, the lender will convert the outstanding balance to a loan repayable in monthly installments (principal and interest) over an extended repayment period. Be mindful that the payment amounts fluctuate over time as the interest rate is typically variable with HELOCs.

What Can You Use the Cash For?

You’re free to use the cash from a home equity loan or HELOC however you want. Consider using a portion to pay off your mortgage – the remainder can eliminate high-interest debt, beef up your nest egg, fund a big-ticket purchase or cover business expenses for your startup. The choice is yours.

Ways to Use HELOC to Pay Off Mortgage

You can pay the balance in full at once or spread it out over the draw period. Suppose you pay the balance in full once you’re approved for a HELOC. In that case, you’ll only pay interest during the draw period, which could free up a load of space in your budget to meet more pressing financial goals. But if you can make extra payments towards the principal, you could curb the amount of interest even more.

It’s also possible to allocate funds from the HELOC to cover your monthly mortgage payment and give your budget breathing room. However, this approach likely won’t save you much unless the interest rate on the HELOC is drastically lower. You also want to ensure the term remaining on your mortgage is equivalent to the draw period. Even still, you’ll be stuck with the balance on your HELOC when the draw period ends.

Steps to Using a HELOC to Pay Off Mortgage

A HELOC is a useful financial product that lets you tap into your home equity. These are the steps you can use to pay off your mortgage with a HELOC.

Step 1: Assessing Your Financial Situation

Homeowners should carefully review their finances and look for other ways to trim their costs and raise their income. A HELOC can solve some short-term financial issues, but it shouldn’t be used to preserve bad financial habits. Consumers should consider how they can improve their financial situation so they do not have to constantly borrow against their home equity to make ends meet.

Step 2: Application and Approval for a HELOC

You will have to gather basic documents like your ID, proof of address, social security number, and other information when applying for a HELOC. It’s also good to apply to multiple lenders, which can lead to a better option than your current mortgage provider. HELOC rates vary, and you can end up with a lower interest rate if you submit multiple applications.

Some online lending marketplaces make it easier to show your information to numerous lenders. These marketplaces have several partners that will offer their rates and terms for a HELOC. Lenders will request that you get a home appraisal to determine how much equity you have available.

Step 3: Using the HELOC Funds to Pay Off Your Mortgage

You can use your HELOC to cover your mortgage loan. Your first mortgage will get paid off, and you will then have to make payments toward your HELOC. Some borrowers can tap into enough equity to get rid of their mortgage balance entirely, while others may only be able to shave off a smaller percentage of their total loan balance.

The large lump sum of money from a HELOC offers plenty of advantages and can help you pay off your mortgage. However, you should check with your current mortgage provider if any prepayment penalty fees will apply.

Step 4: Managing the HELOC’s Repayment

HELOCs have more generous monthly repayments than mortgages. You will have some breathing room in your budget, but it’s important to pay off a HELOC balance as quickly as possible. These financial products have variable rates which can go higher over time. If your credit score takes a hit, your HELOC rate is likely to go up. It’s not a fixed rate like a home equity loan.

It’s optimal to pay off your entire home equity line of credit before the draw period concludes. This draw period typically lasts for 3-10 years but varies for each lender. Trimming your principal balance now instead of waiting for the HELOC’s drawing period to conclude can help you avoid additional costs and save money. Even if a HELOC gets converted into a home loan with fixed monthly payments, reducing the balance will result in lower monthly payments when that time arrives.

Is It Smart to Use a HELOC to Pay Off Your Mortgage?

Using a HELOC to pay off your mortgage may sound good on the surface. A borrower gets lower monthly payments and more time to make their payments. They can draw funds from a HELOC for several years until the draw period concludes.

However, a HELOC borrower can end up with additional costs. You will have to incur the closing costs for a HELOC, which can range from 2% to 6% of the credit line’s balance. You may also have to contend with prepayment penalties from your current mortgage lender. Homeowners can kick these costs further down the road by borrowing more equity, but this decision can keep you in debt longer and enable bad financial habits.

A HELOC can make more sense if interest rates drop significantly and your existing mortgage has a higher interest rate than a HELOC. This context makes it possible to save money by paying off your original mortgage with a HELOC. Just make sure you have a strategy for staying on top of your HELOC balance so you get close to paying it off before the draw period (or pay it off completely).

Pros and Cons of Using a HELOC to Pay Off Your Mortgage

Key Benefits:

• You’ll only pay interest on the amount you borrow.
• The interest rates are generally lower than what you’d get with a personal loan.
• You’re not obligated to borrow the total amount you’re eligible for.
• You can use the funds however you see fit.

Key Drawbacks:

• The monthly payments could change over time with the variable interest rate.
• You can’t buy points to lower the interest rate.
• You could lose your home if you default on the payments.

Alternatives to Using a HELOC to Pay Off a Mortgage

You don’t have to use a HELOC to pay off your mortgage. These are some of the viable alternatives to consider.

Making Additional Payments Toward the Principal

Mortgage lenders use an amortization schedule for repayments that prioritize interest payments in the beginning. As you get closer to the end of your term, a higher percentage of your monthly payment goes toward the principal.

Homeowners can make additional payments toward their mortgages each month. It’s a useful loophole that can get you out of debt several years earlier. That’s because a second monthly mortgage payment allows you to cut down on your mortgage’s principal. Any extra payments do not contend with interest getting in the way.

Mortgage Refinancing Options like Cash-Out Refinance

A mortgage refinance is another great way to tap into your available equity. It can also help you avoid a HELOC while offering more flexibility. You can choose from several types of mortgage refinancing options.

A cash-out refinance allows you to get a new mortgage with a higher balance. The difference becomes accessible cash that you can use for any purpose. Some people use a cash-out refinance to cover a big purchase, but you can also store the extra funds for monthly mortgage payments.

If you have $400,000 on your mortgage and end up with a $600,000 balance after a cash-out refinance, you can save the extra $200,000 and use it for monthly mortgage payments. While it’s better to avoid this scenario and look for ways to make your current mortgage payments on time, the extra buffer is similar to what you can get with a HELOC.

Rate and Term Refinance

A rate and term refinance is another useful option. While a few people may opt for shorter loan terms and get out of debt sooner, many people use this financial product to reduce their monthly payments.

This refinance can reduce your monthly payments in two ways. You can end up with a lower interest rate if your credit score has improved and the Fed has reduced the market rate. A lower interest rate can also help you get out of debt sooner if you make additional mortgage payments each month.

The second way to lower your monthly mortgage payments is by extending your payback period. This strategy will keep you in debt longer and result in more interest. However, you can take your principal and spread it across more monthly payments. You will have lower monthly payments if you pay $500,000 over a 15-year term compared to paying that same amount in a 10-year term.

Home Equity Agreement

Both home equity loans and HELOCs can be used to pay off your mortgage, but you’ll be forced to take on even more debt to leverage these tools. Or you can get a home equity agreement and tap into your equity without borrowing more money.

A home equity agreement is a debt-free option you can use to convert your home’s equity into cash. It’s an arrangement between a homeowner and investor that gets you money today in exchange for a share of the future profits in your home.

You won’t have to refinance your home. Even better, you’ll have ten years to decide if you want to sell your home or buy out the agreement.

Below is a breakdown of home equity agreements work:

• Step 1: The homeowner is offered a lump sum payment or co-investment in exchange for a percentage of the future increase in value.
• Step 2: The home is appraised to ensure the offer is viable.
• Step 3: The homeowner reviews the closing documents and signs on the dotted line.
• Step 4: The homeowner receives the cash for the co-investment.

At the end of the agreement, the homeowner either sells the property or buys out the contract. Either way, the investor receives their initial co-investment plus their share of the profits. (Some investors also share in the losses, assuming you don’t sell the home before an agreed-upon date as specified in the contract).

However, this alternative can become more expensive behind the scenes. If your home’s value increases, you won’t benefit as much from the price expansion. According to Norada Real Estate, Florida home values jumped 80% from 2018 to 2022. A homeowner with a $500,000 property would have seen their investment jump to $900,000 during that same time frame. If the homeowner gave up a percentage of their home’s future increases in value, they could have missed out on great gains. While each real estate market is different, you will miss out on some of those gains if you opt for a home equity agreement. If you take out a home equity loan or HELOC, you do not have to worry about this risk.

Conclusion: Should You Use a HELOC to Pay Off Your Mortgage

A HELOC can pay off your mortgage and reduce your monthly payments. This financial product can offer short-term relief, but it creates additional costs and can compound quicker than a traditional mortgage. A HELOC may be a good choice if you can quickly pay off the balance. However, you can end up owning more money in the long run between a higher rate, compounding interest, and fees.

FAQs About Using a HELOC to Pay Off Mortgage