How to use a HELOC to pay off your mortgage

The average mortgage takes 30 years to pay off, but that doesn't mean you have to wait that long.

Say hello to a Home Equity Line of Credit (HELOC)—a loan that can shave years off your mortgage term and lower your monthly payments.

Read on to learn how to pay off your mortgage with a HELOC.

What is a HELOC?

A HELOC is a loan that allows you to borrow money against the equity you have built up in your home.

For example, if your house is worth $100,000, and you have paid $50,000 on your mortgage, you can borrow up to $42,500 from a HELOC. Lenders typically offer between 80%-85% of the value of the equity you hold.

HELOCs offer a revolving line of credit, allowing you to access funds up to your credit limit, repay them, and re-borrow as needed. Usually, the interest rate is variable and subject to fluctuating market conditions.

How HELOCs work

Like a credit card, HELOCs let you borrow against your spending limit as often as needed. To set your interest rate, your lender will start with an index rate (a reference rate) and add markup based on your credit score.

A HELOC typically consists of two distinct phases:

The 10-year draw period: You can borrow money from your HELOC account. Monthly payments during the draw period are often interest-only, though you can pay down the principal (the amount borrowed, plus interest) to save on long-term costs.

The 20-year repayment period: You can no longer withdraw funds from the HELOC account and must begin repaying what you borrowed.

Monthly payments during the repayment period include principal and interest, which can be significantly more than the draw period.

The pros and cons of HELOCs

HELOCs frequently feature more attractive interest rates than conventional loans, providing financial flexibility during the draw period.

But it's important to know that unless you have a locked-in rate, these interest rates are susceptible to market fluctuations, which could increase payments over time.

Toward the end of the loan, there might also be a substantial lump sum outstanding, known as a balloon payment, that will cover any remaining principal not paid during the life of the loan.

To prevent such large repayments, you can increase your payments beyond the minimum requirement during the repayment phase.

Another strategy is to explore refinancing with a different lender, allowing you to modify the loan terms to better align with your current financial circumstances.

What to consider before taking out a HELOC

Make sure you have a good understanding of your income, expenses, and debt before you take out a HELOC. You'll need to be able to afford the monthly payments, even if interest rates go up.

• Equity: Ideally, you want to have at least 20% equity in your home before applying for a HELOC to ensure a lower interest rate
• Credit score: Lenders have different credit score prerequisites but generally favor a credit score of 700 or above
• Potential home loss: Whenever you utilize your home as collateral, there's a potential risk of foreclosure if you fail to keep up with your payments
• Additional fees: HELOCs may come with extra expenses, such as appraisal fees, early payoff penalties, and annual fees. So, compare offerings from multiple lenders to get the best terms

How to use a HELOC to pay off your mortgage faster

Now for some ways you can use a HELOC to pay off your mortgage faster:

• Pay off your entire mortgage
• Pay off a portion of your mortgage
• Make larger monthly payments
• Refinance your mortgage

If you get a HELOC larger than the amount you owe on your mortgage, you can pay the mortgage off in full and then pay off the HELOC at a lower interest rate.

For example, let's say you have a $300,000 mortgage with a 30-year loan period and a 7.5% interest rate. You've already paid $100,000, so your remaining balance is $200,000, and you also have a HELOC loan of $100,000.

A potentially reduced interest rate, such as 6%, would translate to a $600 monthly payment, leading to significant savings of $84,537 over time. This is a sound strategy if you have a lot of equity in your home and not much left on your mortgage.

HELOCs vs. home equity loans

While both are used to pay off mortgages, HELOCs and home equity loans diverge in loan amounts, interest rate structures, and repayment processes.

• Loan amounts: A home equity loan provides the entire loan amount upfront, and your monthly payments are based on the total sum borrowed. Conversely, a HELOC establishes a maximum borrowing limit, and your repayment amount hinges on the specific amount you withdraw from the line of credit
• Fixed and variable interest rates: Home equity loans typically have fixed rates, ensuring consistent monthly payments throughout the long term. In contrast, HELOCs offer variable-rate options, although some lenders may offer fixed-rate HELOCS with rate change caps
• Repayment schedules: With a home equity loan, you must make full monthly payments for the loan term. HELOCs follow a different pattern, necessitating partial payments during the draw period and more substantial monthly payments, or even a balloon payment, during the repayment period

When to pay off your mortgage with a HELOC

One of the primary advantages of a HELOC is its flexibility.

Should you manage to pay off your mortgage ahead of the repayment period, you can utilize the HELOC for tax-deductible home improvements or to cover expenses like college tuition or medical bills.

However, it's important to remember that while you initially make interest-only payments, you still have to repay the principal amount.

Consider consulting with a financial advisor to make sure you have a well-structured financial plan to settle the full amount without straining your finances.