How to Use a HELOC to Pay Off Your Mortgage

Why Might You Pay Off Your Mortgage With a HELOC?

You build equity in your home as you pay down your mortgage and when its value increases. In some scenarios, it may make sense to tap into your home equity and pay off your remaining mortgage balance with a HELOC.

Once approved, you could pay off your mortgage and then make payments to your HELOC instead. You could even pay off a portion of your mortgage rather than the full balance.

Paying off your mortgage with a HELOC may boost your cash flow by paying off your home early, lowering your monthly mortgage payments and allowing you to pay less interest. Additionally, you could use any available credit left over for other goals, such as renovating your home or paying for a child's college tuition.

Say, for example, you have 10 years left on a 30-year mortgage for $250,000 with a 6% interest rate. Your mortgage balance is $135,009 and your home's value is currently $400,000, leaving you with $264,991 in equity. In this case, you could borrow roughly half of your equity, 50.09% to be exact, to pay off your home loan.

How to Pay Off Your Mortgage With a HELOC

To pay off your mortgage with a HELOC, a lender must approve you for a HELOC with a credit limit sufficient to pay off the mortgage. The amount you're eligible to borrow largely depends on how much equity you have in your home and the lender's maximum allowed. While some lenders have higher maximums, generally, you can borrow up to 80% of your combined loan-to-value ratio (CLTV), meaning the total amount of your current mortgage loan and your HELOC can't be more than 80% of your home's value.

HELOC Qualifications

Eligibility criteria for a HELOC varies from lender to lender, but some requirements are common, such as:

• You should have good credit. While you may qualify for a HELOC with a credit score as low as 680, a credit score of 700 or higher is best. The higher your credit score, the better your odds of qualifying for a loan and scoring a lower interest rate.
• You must have equity in your home. Most lenders will require a minimum of 15% to 20% home equity.
• Your debt-to-income ratio (DTI) should be below 43%. DTI measures how much of your total monthly income goes toward paying your debts. Lenders typically want your DTI to be no higher than 43%, but the lower, the better.
• You'll need sufficient income and documentation. As with other loans, you'll need adequate and stable income to show your lender you can repay your loan. Be prepared to provide your lender with supporting documents like recent pay stubs, W-2s and federal tax returns.

You'll also need to supply many of the same documents as when you applied for your current mortgage, including:

• Driver's license or government photo ID
• Estimated home value
• Current mortgage balance and monthly payment amount
• Bank and investment account information

How to Use HELOC Funds

Once approved, you won't automatically receive a lump sum like you would with a home equity loan or cash-out refinance. That's because HELOCs are similar to credit cards, where you have access to a line of credit you can draw from as needed with a variable interest rate.

Your funds will be directly deposited into your bank account, rather than your mortgage account. You'll have access to your funds once your loan closes and your three-day right of rescission period ends. You can then pay some or all of your mortgage and begin making payments on your new HELOC loan.

Your HELOC term can last from five to 30 years, consisting of two periods:

• Draw period: This period can range from five to 10 years, during which you can tap into your available credit while making interest-only payments.
• Repayment period: After the draw period concludes, you'll enter into a payback period that lasts five to 20 years. At this time, you won't be able to access more funds and you must make principal and interest payments.

You'll free up cash during the draw period since your payments will only need to cover interest. Understand, however, that your payment will significantly jump when you begin the repayment period, so you must prepare for higher payments to avoid falling behind on your mortgage.

Is It a Good Idea to Pay Off Your Mortgage With a HELOC?

There are a number of variables to consider before deciding whether you use a HELOC to pay off your mortgage.

Like credit cards, HELOCs have variable interest rates that can rise and fall. As interest rates change, your monthly payments increase or decrease in turn. And depending on the interest rate for your primary mortgage, you may end up with higher or lower monthly payments or begin with lower payments that rise over time.

Pros of Paying Off a Mortgage With a HELOC

Besides the ability to pay off your home ahead of schedule, this strategy delivers several additional benefits.

• Low interest rates: Since HELOCs are secured by your home, interest rates are typically lower than those for credit cards and personal loans.
• Low (or no) closing costs: While HELOC closing costs typically range from 2% to 5%, many lenders now offer HELOCs with no closing costs.
• Flexibility: While you can use your funds to pay off a portion or all of your mortgage, you can use HELOC proceeds for almost any purpose. For example, you could also opt to use some of the money for home improvements or other important goals.

Cons of Paying Off a Mortgage With a HELOC

As you might imagine, using a loan to repay your mortgage comes with real risks.

• Secured by home: Perhaps the most significant risk HELOCs pose is that your home serves as collateral on the loan. That means your lender can foreclose on your home if you don't repay the money as agreed.
• Variable rate: The interest rate on HELOCs is variable, meaning your rate could rise or fall depending on what's going on in the market. Facing such unpredictability, it's a wise practice to prepare your budget to make larger payments.
• Fees and penalties: It pays to compare HELOC lenders as some charge for closing costs and annual fees. What's more, some lenders impose a prepayment penalty if you pay it off before the repayment term ends.

The Bottom Line

You may be able to use a HELOC to pay off a mortgage, but should you? As with most financial decisions, the answer may depend on your unique circumstances.

This strategy may make sense if you have a relatively low mortgage balance and your primary loan has a high interest rate. Having a large amount of equity in your home could make it easier to qualify for a HELOC, with a lower interest rate than your current mortgage.

Of course, using your home as collateral is a risk with serious consequences. Like your current mortgage, a lender can foreclose on your home if you default on a HELOC.

To qualify for a HELOC with low interest rates, you'll need a good credit score. If your credit is lower than you'd like it to be, consider taking steps to improve your credit score before you apply. Begin by checking your credit report and credit score for free with Experian.