Should you use a HELOC to pay off your mortgage?
Key takeaways
- Using a HELOC to pay off your mortgage can be a strategic move, especially if you have a lot of equity in your home and a small outstanding mortgage balance.
- Opening a HELOC to pay off your home loan will still leave you with an outstanding debt and interest — and unlike most mortgages, HELOCs have variable interest rates, which can increase.
- Alternatives to HELOCs include home equity loans or just making bigger or extra payments on your existing mortgage.
Many mortgage-holding homeowners today are sitting on significant equity in their homes: about $319,000 worth, according to ICE Mortgage Technology, which tracks real estate data. If you’re one of them, you might be wondering if it makes sense to use a home equity line of credit (HELOC) to pay off your mortgage.
The strategy could be a shrewd one, especially if the remaining balance is fairly small. But a lot depends on interest rates past and present. Here’s what to know about paying off your mortgage with a HELOC — and the risks that come with doing so.
How to use a HELOC to pay off your mortgage
First, let’s look at how you’d literally use a HELOC to settle your mortgage debt.
1. Shop for a competitive rate
HELOC rates can vary greatly between lenders. Evaluate different options and investigate what HELOC rate you qualify for. Compare the rates and terms available against your current mortgage to determine whether you would benefit from taking this step. Remember, HELOCs come with variable rates, so you want a big margin with room for upward direction.
2. Apply for a HELOC
If you find a line of credit with a favorable interest rate and terms, go ahead and apply. The process is similar to applying for a mortgage, albeit slightly more streamlined. You’ll have to submit paperwork documenting assets, debts and employment; have a home appraisal done and allow a check of your credit score and history. The criteria to qualify for a HELOC can be more stringent than for a mortgage: Typically, you will need to have at least 15 to 20 percent equity in your home, a credit score in the mid-600s, and a debt-to-income ratio of 43 percent or less. Expect a processing time of between two and six weeks from when you apply to when you receive approval and access to your line of credit.
3. Draw your HELOC funds
Once you can access your line of credit, you can borrow against the available equity in your home either over your HELOC’s draw period or all at once. HELOCs come with checks or, increasingly, debit cards; you can also make electronic transfers between the HELOC and another bank account. If your HELOC lender is also your mortgage lender, you might even be able to apply the credit line funds directly to your mortgage payments.
4. Pay off your mortgage and maintain regular HELOC payments
Assuming you qualify for enough of a HELOC to pay your mortgage balance off in full, you can do so as soon as you have access to your line of credit. Keep an eye out for documents confirming the establishment of your HELOC, and focus on staying current with HELOC payments moving forward.
What are the requirements to qualify for a HELOC?
- At least 15 to 20% equity in your home
- A credit score in the mid-600s
- A debt-to-income ratio of 43% maximum
When to pay your mortgage with a HELOC
There’s no set equity amount or principal due that indicates when you should use a HELOC to pay off a mortgage. Much depends on the amount of equity you started with — that is, how much of the home you paid for in cash/how big a down payment you made — and how much of your mortgage balance is outstanding. Obviously, the longer you’ve been making your payments, the more equity you’ve built up, and are able to tap.
Mainly, though, it all comes down to interest rates. You should only pay off a mortgage with a HELOC if you can get a significantly better interest rate on the line of credit than you currently have with your mortgage. Because the HELOC’s rate is variable, it needs to be much lower than your mortgage rate — with room to increase — for this move to make financial sense. And because HELOCs generally have higher rates than mortgages, you might be hard pressed to make this math work.
If your mortgage is still sizable, you might convert it to a first-lien HELOC.
First-lien HELOCs blend the characteristics of a traditional mortgage and a home equity line of credit, functioning as the primary loan on your home. Unlike a standard HELOC, which complements your mortgage, a first-lien HELOC replaces it. So it gets repayment priority in case of default, which can influence creditors. (A standard HELOC is in second place to get repaid.)
Some of these loans have set draw periods, while others, known as “all-in-one mortgages,” allow continuous access to your home’s equity throughout the entire term. By linking a checking account, funds are automatically applied to reduce the balance, enabling you to lower the principal and save on interest with each deposit. Instead of fixed payments, you pay variable interest based on the average daily balance from the previous month, offering flexibility and versatility.
A first-lien HELOC has its pros and cons. It can serve as an effective cash flow management tool, automatically reducing the balance whenever your paycheck or other income is deposited. And it provides access to a larger pool of funds and doubles as a way to accelerate mortgage repayment. However, qualifying requires solid financials and the consistent repayment demands a high level of discipline.
When not to use a HELOC to pay off your mortgage
You should pass on using a HELOC to pay off your mortgage if the numbers don’t make sense: that is, if the interest rates on the home equity line of credit are higher than those on your current mortgage. Even if they’re lower now, the variable rate that comes with HELOCs means you could easily find yourself spending more in interest over time than with your current mortgage.
There’s also a tax consideration, if you itemize deductions on your return: Mortgage loan interest is deductible, but HELOC loan interest to repay a mortgage probably would not be (you need to use the funds to buy, repair or substantially improve your home).
Even if HELOC interest rates are substantially lower, consider where you are in your mortgage term. If it’s far enough along so that your payments are going mostly toward the principal, you might want to stick with the loan. Why trade those in for paying HELOC interest?
Pros and cons of using a HELOC to pay off a mortgage
Benefits of using a HELOC to pay off your mortgage
- Flexibility: HELOCs are a more flexible form of financing in that you can borrow only what you need versus the entire amount you were approved for. For instance, if you don’t want to use all of the HELOC funds to pay down your mortgage, you might decide to devote some of the money to home renovations or other expenses. You can also withdraw different amounts at different times.
- Low or no closing costs: Although HELOC closing costs can range from 2 percent to 5 percent of the amount you’re borrowing (similar to a mortgage), some lenders offer no-closing-cost HELOCs. The cost of borrowing this money might be lower than other options you might be considering, like a cash-out refinance.
- Access to more money: Repaying HELOC draws replenishes the credit line, allowing you to borrow the funds again (until the draw period ends). So a HELOC provides ongoing access to funds, which can be valuable for consolidating debt, home renovations or other financial needs.
- Chance for a lower rate: If your current mortgage has a higher interest rate and the HELOC has a lower rate, you can use the funds from the HELOC to pay off your mortgage sooner for less. This depends largely on the broader mortgage market, however.
Risks and downsides of using a HELOC to pay off a mortgage
- Fluctuating interest: HELOCs come with a variable interest rate, which means your rate will fluctuate over time based on market conditions. There’s no way to predict whether your rate will move up or down in the future, so you’ll need to be prepared to fit higher payments into your budget.
- More debt: While you can pay off a mortgage with a HELOC, you’d also be replacing that debt with another form of debt, and you might end up paying more interest than you would have with your current mortgage. This has implications for your credit score and finances — especially if it’s not helping you save money in the long run.
- You could lose your home: As with your mortgage, your home will need to serve as collateral for the HELOC. If you don’t repay your debt as agreed upon, you could lose your property to foreclosure.
- Fees and penalties: Many HELOCs carry an annual fee, and some come with a prepayment penalty if you settle the balance and close the credit line ahead of schedule.
- Tax disadvantage: If you itemize, your mortgage interest is tax-deductible. Your HELOC’s interest may not be if you’re using it for this purpose — generally, you’d need to be using the funds to “buy, build, or substantially improve the home.” Definitely check with a tax pro.
Is it a good idea to pay off your mortgage early with a HELOC?
Prepaying your mortgage can certainly save you money in the long run. However, using a home equity line of credit (HELOC) to do so has limitations.
First of all, lenders typically only allow you to borrow up to 80 percent (sometimes 85 percent) of your equity in your home. Depending on your specific financials, this might not be enough to pay off your mortgage entirely.
Secondly, whatever funds you use from the HELOC need to be paid back: The repayment period typically lasts 20 years. If you’re close to paying off your current mortgage, you might not want to commit to repaying another debt over two more decades, especially if you’re nearing or in retirement and on a fixed income. (Of course, there’s no law that says you can’t settle the HELOC balance early, though there may be a prepayment fee to do so.)
But the biggest reason to pause if you’re considering using a HELOC to payoff a mortgage: interest rates. Although they both use your home as collateral, HELOCs tend to cost more than mortgages. Currently, their interest rates are around 8.28 percent, compared to 7.11 percent for the average 30-year mortgage, purchase or refinance. Also bear in mind that, unlike most mortgages, most HELOCs have fluctuating interest rates and rates have risen consistently since the pandemic, reflecting the Federal Reserve’s series of rate hikes to contain inflation. Although they’ve been on a downward course in the last several months, as the Fed’s cut its benchmark lending rate, HELOCs remain a fairly expensive form of financing.
All of this means an older mortgage could cost less than a contemporary HELOC. “Even if the Federal Reserve lowers rates [more] in the next 12 months, older mortgages could still remain competitive compared to new HELOCs,” says Herman (Tommy) Thompson, Jr., CFP of Innovative Financial Group in Atlanta. “The rise in interest rates since 2022 has been quite aggressive. It’s unlikely that interest rates on a new HELOC will be lower than a mortgage obtained prior to 2022.”
Alternatives to HELOCs to pay off a mortgage
If you’re unsure about a HELOC, here are some other options.
Extra mortgage payments
If your goal is to simply settle your mortgage early, and you have extra cash, you’ll likely be better off making extra payments, if possible — especially in the current elevated-interest-rate environment. You might opt to pay extra in a lump sum or begin making biweekly payments. Even one more payment a year can speed up the payoff process.
Home equity loan
Consider taking out a home equity loan, the HELOC’s fixed-rate cousin. It’s more akin to your mortgage: You’ll receive the funds in a lump sum, and start repayments (both principal and interest) immediately. But your monthly payments won’t fluctuate. However, you’re still borrowing money to pay off borrowed money, which isn’t ideal, especially with interest rates as high as they are right now (HELoan rates are comparable to HELOCs’, and higher than mortgage rates). You’ll also incur closing costs when you take out the loan.
Reverse mortgage
A reverse mortgage is a loan for homeowners aged 55 or older, enabling them to tap into their home’s equity and receive tax-free payments to use as they wish (the lender pays them, hence the “reverse”). Borrowers can choose to receive payments as monthly installments, a line of credit, or a lump sum. They don’t have to make any repayments, though interest does accrue monthly. The loan amount depends on factors such as borrower’s age, home value, interest rates and the size of the equity stake. When the homeowner moves out, sells the property, or passes away, the reverse mortgage gets repaid in full, or the home gets transferred to the lender.
Refinance
Another way to pay off your current mortgage is by refinancing it. A refinance replaces your current mortgage loan with a new one, offering the option to change the interest rate, loan term or both. One type, the cash-out refi, also allows you to take out a lump sum, borrowed against the equity you’ve built up in your home. Refinance rates are close to primary mortgage rates, so they’re usually cheaper than HELOCs. However, they can end up being more expensive overall if mortgage rates have risen since your original loan. And again, you’ll incur closing costs between 2 to 5 percent of the loan amount.
The bottom line on using a HELOC to pay your mortgage
A home equity line of credit is a powerful resource in your toolkit for achieving financial goals like consolidating debt, which could include paying off your mortgage. With this strategy, essentially you’re using your ownership stake in your home to pay off what you still owe on your home. But remember: You’re essentially shifting debt, not eliminating it altogether.
So, paying off a mortgage with a HELOC only makes sense if you can get a significantly lower rate on a HELOC than you currently have on your home loan, and/or you really want to be able to benefit from interest rate declines. At their current rates, HELOCs are no longer super-cheap: The costs will likely outweigh the benefits. But it never hurts to crunch the numbers for your particular case.
Additional reporting by Erik Martin
