How to use a HELOC to Pay Off Your Mortgage

You might be contemplating the idea of utilizing a home equity line of credit (HELOC) to pay off your mortgage, particularly if the remaining balance is relatively low.Presently, numerous homeowners possess substantial equity in their properties. Understanding the dynamics of paying off your mortgage using a HELOC and being aware of the associated risks is crucial.

Adam Carroll Shred Method

An early advocate of utilizing HELOCs to expedite mortgage repayment was Adam Carroll, the creator of The Shred Method and a fintech platform developer. The strategy involves treating a HELOC as a checking account, where funds are drawn to make lump sum payments towards the mortgage, while all discretionary income is channelled towards repaying the HELOC.

This method capitalizes on the typically lower interest rates offered by HELOCs compared to other forms of debt, aiming for interest rate arbitrage. By doing so, borrowing costs are significantly reduced, leading to quicker elimination of mortgage debt. According to The Shred Method’s website, the average participant achieves mortgage freedom in slightly over four years.

Using HELOCs strategically, like with The Shred Method, can swiftly clear mortgage debt thanks to lower interest rates. With disciplined execution, borrowers can be debt-free in around four years.

Presently, numerous homeowners possess substantial equity in their properties. As per ICE Mortgage Technology’s data from Q1 2024, the average homeowner now holds around $299,000 in equity.

Current HELOC rates:

current HELOC rates for different banks:

How to calculate your HELOC:

Determine Available Equity: Calculate the equity available in your home, which is typically assessed based on the property’s current appraised value and any outstanding mortgage balances.

Consider Lender Limits: Understand your chosen lender’s loan-to-value (LTV) ratio limits. Lenders typically allow opening a line of credit against a portion of your available equity, often ranging between 75% and 85%.

Calculate Maximum HELOC: Multiply your home’s value by the lender’s LTV limit to determine the maximum HELOC amount you qualify for. For instance, if your home appraises for $400,000 and the lender’s LTV limit is 80%, your maximum HELOC would be $320,000.

Adjust for Remaining Mortgage Balance: If you have an existing mortgage balance, subtract it from the maximum HELOC amount to account for the lender’s LTV requirement. For example, if your remaining mortgage balance is $110,000, your available HELOC would be $210,000.

Remember, these calculations are based on various factors including credit score, income, location, and lender requirements. Your specific HELOC amount may vary depending on these variables.

When to pay your mortgage with a HELOC

Determining when to utilize a HELOC to pay off your mortgage isn’t solely based on a specific equity amount or a percentage of your remaining loan. Instead, it hinges on various factors, including your initial equity investment and the outstanding balance of your mortgage. Naturally, the longer you’ve been making payments, the more equity you’ve accrued and can access.

However, the primary consideration is the interest rates. Opting to pay off your mortgage with a HELOC is only advisable if you can secure a substantially lower interest rate on the line of credit compared to your existing mortgage rate. Given the variable nature of HELOC rates, the margin between the HELOC rate and your mortgage rate should be significant enough to accommodate potential rate increases before it becomes financially advantageous. Since HELOCs generally carry higher interest rates than mortgages, it may prove challenging to justify this strategy from a financial standpoint.

Advantage of using a HELOC to pay off your mortgage:

• Flexibility: HELOCs offer flexibility as you can borrow only what you need, allowing you to allocate funds for other purposes like home renovations or expenses.

• Low or no closing costs: Some lenders offer HELOCs with low or no closing costs, potentially making borrowing more affordable compared to alternatives like a cash-out refinance.

• Chance for a lower rate: If the HELOC offers a lower interest rate than your current mortgage, you may be able to pay off your mortgage sooner and for less.

How to use a HELOC to Pay Off Your Mortgage

Here’s a step-by-step guide on using a HELOC to pay off your mortgage:

Shop for a competitive rate:

Start by comparing different HELOC options to find the most favourable interest rates and terms. Ensure that the rates and terms offered provide a significant advantage over your current mortgage. Since HELOCs come with variable rates, prioritize finding a margin that allows room for potential rate increases.

Apply for a HELOC:

Once you’ve identified a HELOC with attractive terms, proceed with the application process. Typically, eligibility criteria include having 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.

How to qualify for a HELOC:

Assess Home Equity and Value: Lenders typically consider your home’s equity and current market value. The amount of equity you have in your home will impact your eligibility for a HELOC.

Review Credit History and FICO Score: Your credit history and FICO score play a significant role in qualifying for a HELOC. Lenders will assess your creditworthiness to determine the terms and conditions of your HELOC.

Consider Location and Property Type: Factors such as your home’s location and type (primary residence, secondary home, investment property) may influence your eligibility for a HELOC.

Evaluate Family Income: Lenders may require proof of income to ensure you have the financial means to repay the HELOC. Your family’s income will be assessed as part of the qualification process.

Account for Existing Liens: Any existing liens on your property, such as mortgage loan balances or other debts secured by your home, will be taken into consideration by lenders when determining your eligibility for a HELOC.

Meeting these eligibility requirements is essential to qualify for a HELOC. Keep in mind that specific criteria may vary depending on the lender, so it’s advisable to consult with different lenders to explore your options.

Receive your HELOC funds:

After applying, anticipate a processing period of two to six weeks before gaining access to your line of credit. Once accessible, you can utilize your HELOC to borrow against the available equity in your home, either gradually over the draw period or in a lump sum.

Pay off your mortgage and maintain HELOC payments: Assuming you qualify for a sufficient HELOC amount to cover your mortgage balance, proceed to pay off your mortgage as soon as you have access to your home’s equity. Stay attentive to documentation confirming the closure of your mortgage loan and ensure timely payments towards your HELOC to maintain financial stability going forward.

Risks of using a HELOC to pay off your mortgage:

• Fluctuating interest: HELOCs come with variable interest rates, subject to change based on market conditions, necessitating budget adjustments for potential rate increases.

• Increased debt: Paying off your mortgage with a HELOC replaces one form of debt with another, potentially resulting in higher interest payments and implications for your credit score and financial health.

• Fees and penalties: Many HELOCs impose annual fees and prepayment penalties if you pay off borrowed amounts sooner than the repayment schedule dictates.

• Tax disadvantage: While mortgage interest is often tax-deductible, interest on a HELOC used for mortgage repayment may not be eligible for deductions unless the funds are used for home-related purposes like buying, building, or substantially improving the home. Consulting with a tax professional is recommended to understand the tax implications fully.

Also Read :How to Get The Equity Out of Your House

when not to use a HELOC to pay off your mortgage

Avoid using a HELOC to pay off your mortgage if the financial calculations don’t align. If the interest rates on the HELOC are higher than those on your current mortgage, or even if they are lower initially but subject to fluctuation, it may not be a prudent choice. Over time, the variable nature of HELOC rates could lead to higher interest expenses compared to your existing mortgage.

Additionally, consider the tax implications. While mortgage loan interest is typically tax-deductible, interest on a HELOC used to repay a mortgage may not be deductible unless the funds are used for home-related purposes such as buying, repairing, or substantially improving your home.

Furthermore, assess your mortgage term. If you’re well into your mortgage and most of your payments are directed towards principal, it might not be wise to switch to a HELOC and start paying interest again. Evaluate whether the potential savings from a lower interest rate on the HELOC outweigh the costs and implications of restarting interest payments.

Risk Management: Before opting for a HELOC to pay off a mortgage, carefully assess your risk tolerance and financial stability. HELOCs come with variable interest rates, which can fluctuate based on market conditions. It’s crucial to have a plan in place to manage these risks effectively, ensuring that you can handle potential increases in interest rates without facing financial strain.

Financial Planning: Take a holistic approach to financial planning when considering a HELOC strategy. Evaluate your long-term financial goals and assess how using a HELOC fits into your overall financial plan. While it may offer benefits in terms of interest savings, ensure that it aligns with your broader financial objectives and contributes to your financial well-being over time.

Professional Advice: Seek guidance from a financial advisor or mortgage expert before proceeding with a HELOC to pay off your mortgage. These professionals can provide personalized advice tailored to your specific circumstances, helping you understand the potential risks and benefits associated with this strategy. By consulting with experts, you can make well-informed decisions that support your financial goals and mitigate any potential challenges.