How to use a HELOC to pay off your mortgage

A home equity loan and home equity line of credit (HELOC) are valuable tools that can help you tap into your home’s equity for cash. You can use a home equity loan or HELOC to pay for any large expense, such as a home improvement project.

In some situations, these home equity financing options may reduce your monthly mortgage payments, or even allow you to pay off your mortgage ahead of schedule. Before you start the process, ensure you understand how to use a home equity loan and HELOC to pay off your mortgage and if you’ll save money in the long run.

How HELOCs work

Unlike home equity loans, which give you a lump sum of money, HELOCs give you access to a line of credit. In this way, HELOCs work like a credit card, letting you draw money as needed up to your maximum limit.

Generally, you can borrow no more than 85% of your combined loan-to-value (CLTV) ratio. The CLTV measures the amount of your current mortgage balance plus the amount you want to borrow against the value of your property.

HELOCs typically come with variable interest rates and two periods:

• Draw period — During this period, which usually runs for 10 years, you can access your credit line as needed up to your limit and make interest-only payments on the amount you borrow.
• Repayment period — This period, which lasts 10 to 20 years, begins once the draw period expires. You can no longer access funds during this time and must make monthly installment payments that include principal and interest.

How to use a HELOC to pay off your mortgage

Taking out a HELOC to pay down or eliminate your original mortgage is an option, but it’s not something everyone should consider. You might save money if you have substantial equity and you can score a lower interest rate, but often the devil is in the details. Consider this example:

Say your home is worth $500,000, and your remaining mortgage balance is $100,000. You took out the mortgage 25 years ago with a 6% interest rate and monthly payments of $2,398.20. If you continue to pay off your home over the next five years, you’ll pay $19,843 in total interest charges over that time frame.

But what happens if you qualify for a $100,000 HELOC with no closing costs, a 3.99% variable interest rate, a five-year draw period, and a 15-year repayment term? Here, you have two options for paying off your original mortgage with a HELOC.

Repay the HELOC within the draw period

With this option, you could still pay off your home in five years, make lower monthly payments, and save on interest. Your monthly principal plus interest payments would be $1,841.20, roughly $557 less than you were making on your original mortgage . Additionally, you’ll pay $10,427 in interest on your HELOC, $9,416 less than you would’ve paid with your original mortgage.

Remember, however, that HELOCs are variable-rate products, meaning your APR and monthly payments could rise with any interest rate increases. Some lenders now offer fixed-rate HELOCs, which could be a better option.

Also, keep in mind, some lenders impose early prepayment penalty fees, so make sure you understand the terms of any HELOC you're considering before enacting this strategy.

Pay the minimum during the draw period

If your income is less than it’s been in the past, you could opt to make minimum interest-only payments during the draw period. Using the example from above, your minimum payment works out to $332 before climbing to $739 during the 15-year repayment period.

In this case, you create significant space in your budget, dropping your monthly payment by about $2,066 during the draw period and $1,659 during your repayment term. Of course, the catch is that you're paying interest over a much longer period of time — 15 years more to be exact — and you’ll pay over $53,000 in total interest.

Again, these numbers don’t take into account any rate increases that could come with a variable-rate HELOC. With this option, you’ll pay more in interest than you would with your original mortgage, but it could create space in your budget.

Should you use a HELOC to pay off your mortgage?

Choosing whether to get a HELOC to pay down your mortgage will depend on your unique financial circumstances. If you have a low remaining balance on your mortgage and can secure a lower interest rate, this option may make financial sense.

On the other hand, if you don’t have a lot of equity and already have a low interest rate, you might not be able to get a HELOC with an APR low enough to make it worthwhile.

Also, a variable-rate HELOC usually isn’t a good option if your income is spotty or irregular. Experiencing a drop in income when interest rates rise can make it difficult to budget for your monthly payments. If you can’t make your payments, you risk losing your home since your house secures your HELOC.

Other things to consider are the upfront costs and annual fees that often come with a HELOC, including:

• Appraisal fees
• Application fees
• Closing costs
• Annual fees
• Inactivity fees
• Early prepayment fees

How to get a home equity loan

A home equity loan may be a better option if you don’t need access to money over an extended period. Home equity loans offer a one-time lump sum payment, which might be all you need to pay for a new roof, install a swimming pool, or fund any other major home improvement. Follow these steps to find a home equity loan that meets your needs:

1. Determine the amount you want to borrow. Understanding how much money you need to achieve your goal will help when you shop and compare loan offers.
2. Calculate your home equity. You’ll need at least 15% to 20% equity to qualify for a home equity loan. To determine how much equity you have, subtract your current mortgage balance from your home’s market value.
3. Shop and compare rates from multiple lenders. Interest rates and repayment terms vary by lender, so it pays to compare multiple loan offers to find the best rate and terms for you.
4. Submit your application. Once you’ve chosen a lender, you’ll want to fill out an application and provide any requested documentation, such as recent pay stubs, bank statements, and employment verification.
5. Sign for your loan. Once your loan processing is complete, you can pay any closing fees and open your new loan account.

How to get a HELOC

If you have at least 15% equity in your home, you may qualify for a HELOC, and lenders will consider your credit, debt-to-income ratio, and other factors. Here are the steps to take to get a home equity loan:

1. Shop and compare lenders. It’s wise to shop with multiple lenders to make sure you’re getting the best deal. Compare loans, interest rates, and terms to find the best HELOC that fits your needs.
2. Gather supporting documents. Before you apply, gather your government-issued ID, bank and investment account statements, pay stubs, W-2s, and other documents that confirm your citizen status, income, and employment.
3. Complete the application. Fortunately, you can usually fill out a home equity loan application quickly and easily online. After submitting your application, your loan agent may ask you to send additional documents or schedule a property appraisal.
4. Close your loan. On your closing date, you’ll sign documents, pay any closing fees, and activate your HELOC. Processing and closing your loan can take two to six weeks.

Which is better: Home equity loan or HELOC?

Deciding between a home equity loan and a HELOC may come down to when you need the money. A home equity loan may be better for you if you need a large amount to cover a large one-time expense, such as an unexpected medical bill.

By contrast, a home equity line of credit might be better if you don’t need all the money immediately because you only pay interest on the amount you borrow.

Before you decide, run the numbers and compare the interest rates, fees and terms of your current loan versus a home equity product.