Key Takeaways
- Home equity loans, or second mortgages, let homeowners borrow a lump sum based on their equity.
- HELOCs provide a flexible line of credit secured by your home, with variable interest rates.
- Using a home equity loan or HELOC to pay off a mortgage can lower interest costs but may include fees.
- HELOCs pose interest rate risks due to their variable rates; payments can increase if rates rise.
- Understand loan terms, interest types, and potential prepayment penalties before using home equity.
Rising home values have given many homeowners significant equity, leading some to consider using a home equity loan, often at a lower interest rate, to pay down their mortgage. This can reduce monthly payments and offer flexibility, but it also brings risks that need careful review. This article explores whether using home equity to pay off a mortgage is a financially sensible choice and outlines the main ways to do it.
1. Understanding Home Equity Loans and Their Benefits
The first is by using a conventional home equity loan, which is sometimes referred to as a second mortgage. This type of loan is essentially the same as a mortgage loan, except that instead of going toward the purchase of a house, it results in the borrower receiving a lump sum of cash that they are free to spend however they desire.
The exact size of this lump sum is calculated as a percentage of the equity that they have in their home, with 85% being a commonly used maximum. For example, if a homeowner has a mortgage for $200,000 but their home is worth $300,000, then their equity would be $100,000. If their home equity loan offers a lump sum of up to 85% of their equity, then they would be able to borrow up to $85,000. Although some homeowners use these funds to pay down their mortgage, they could also take out a home equity loan to cover other costs, such as remodeling their kitchen or paying for college.
The main reason why homeowners take out home equity loans to pay down their mortgage is that they think doing so will result in lower monthly payments. This can occur when interest rates have declined since they first purchased their home, meaning that the home equity loan would carry a lower interest rate than their existing mortgage. In this scenario, the homeowner would take out a home equity loan, which would have its own interest rate, amortization schedule, and term, and essentially would be refinancing some or all of their existing mortgage.
Although using a home equity loan to refinance your mortgage can lead to lower interest costs, homeowners need to be careful to ensure that this cost savings is not wiped out by any prepayment penalties or closing costs that might apply. Depending on the details of their existing mortgage terms, it may be more efficient to simply wait until the next available opportunity or refinance their mortgage, through either their existing lender or a competing lender.
2. Exploring the Flexibility of Home Equity Lines of Credit (HELOCs)
The second way that homeowners can use their home equity to pay down their mortgage is by taking out a home equity line of credit (HELOC). As its name implies, HELOCs are a line of credit that is secured by your home. Like a second mortgage, the amount of money that you can borrow under a HELOC is calculated by taking a percentage of your home equity, typically similar to that which is used for second mortgages. But aside from these similarities, there are several important differences between HELOCs and second mortgages.
To begin with, HELOCs do not give the lender a lump sum at the start of the loan. Instead, they function like a personal line of credit, allowing the homeowner to borrow up to a certain amount, but letting them decide when and how much to borrow. This makes HELOCs well suited for homeowners who want the option of borrowing against the equity in their home without having any immediate plans for how to use the money.
The second important difference between HELOCs and second mortgages is that HELOCs only require you to pay the interest on the loan each payment, allowing the borrower to choose when they pay back the principal. By contrast, second mortgages follow a strict amortization schedule in which each payment includes both interest and principal. Technically, HELOCs offer a period of time, called a draw period, in which the borrower is free to pay only interest. However, at the end of the draw period, the HELOC converts to an amortization schedule, forcing the borrower to gradually pay back any principal that they borrowed.
The third major difference between HELOCs and second mortgages is that HELOCs offer variable interest rates. In situations where interest rates have declined since you obtained your mortgage, this could make using a HELOC to pay off part of your mortgage an attractive option because it could lead to lower monthly payments overall. However, as is often the case in finance, there are pros and cons to this approach.
Analyzing the Risks of Using Home Equity for Mortgage Reduction
At first glance, using a HELOC to pay down your mortgage seems like a very attractive option. After all, it could allow a homeowner to take advantage of a lower interest rate while also delaying paying principal on the loan, potentially reducing their monthly payments by a substantial amount.
However, the main risk with this approach is that it exposes you to interest rate risk. HELOCs are a variable interest rate loan, which means that if interest rates rise, so would your payments. This risk is further amplified if you take the approach of making only interest payments and delaying repaying principal, since that unpaid principal would then incur interest at a higher rate once interest rates rise.
To protect against this, homeowners would benefit from stress testing their mortgage repayment strategy by calculating how much additional interest they could afford to cover if interest rates do rise. Similarly, it may be prudent to set aside money in a readily accessible fund that could be used to pay down principal quickly if interest rates rise, to avoid being stuck with many months’ or even years’ worth of higher interest payments.
Important
Homeowners need to carefully evaluate the terms of the home equity loans they are considering. Important terms to be familiar with include whether the loan offers a fixed or variable interest rate, the length of the draw period or amortization period, whether the loan charges simple interest or amortized interest, and any rules or penalties regarding prepayment of principal.
Can I Use Equity to Pay Off My Mortgage?
Yes. There are many ways to use equity to pay off your mortgage, but two of the most common approaches are second mortgages and home equity lines of credit (HELOCs). Second mortgages have the same payment each month and give you a lump sum at the start of the loan, which you could use to pay off some or all of your mortgage. HELOCs are a revolving line of credit that you are free to withdraw from or repay as you see fit. Both of these loans carry much lower interest rates than credit cards or other unsecured loans, because they use your house as collateral.
What Happens to My HELOC When I Pay Off My Mortgage?
When you pay off your mortgage, the HELOC would be paid off at the same time. For example, if you sell your house, then before you receive any of the proceeds of the sale, both your mortgage and your HELOC would need to be paid off first. The lenders would have first claim on the proceeds from the sale.
Can I Pay Off a Home Equity Loan Early?
Yes, you generally are able to pay off a home equity loan early, although this can vary depending on the terms of the specific loan. HELOCs in particular are designed to offer maximum flexibility, particularly during their initial draw period. Mortgages and second mortgages can typically also be repaid early, although they may be subject to prepayment rules and penalties.
The Bottom Line
Using a home equity loan to pay off a mortgage can be a workable strategy for some homeowners, but it won’t suit everyone. It’s important to fully understand the terms of both home equity loans and HELOCs and to stress-test your repayment plan against possible interest rate increases. Careful planning helps ensure the borrowed funds remain manageable under different financial conditions.