Using a Home Equity Loan or HELOC to Pay Off Your Mortgage

As a homeowner, you’ve built equity over the years by paying down your mortgage and watching your home value increase. In some cases, it could make sense to tap that equity to zero out what you owe on the first mortgage.

You might be able to reduce your monthly mortgage payments, save on interest, and pay off your home ahead of schedule.

How home equity loans work

When you take out a home equity loan, a lender gives you a lump sum of money that you’ll repay in fixed installments over time, usually five to 30 years. The amount you can borrow depends on the amount of home equity you’ve built.

Interest rates on home equity loans are usually lower than rates you’d find on an unsecured personal loan or credit card because your home serves as collateral. But if you can’t pay back the loan, your lender has the right to foreclose on your property.

Pros of a home equity loan

• Fixed repayment terms: Home equity loans usually come with a fixed rate and fixed payments. That means you’ll know exactly how much you owe each month and when the loan will be paid off.
• Low interest rates: Because your home serves as collateral, home equity loans usually have lower interest rates than you’d get with other products, such as credit cards and personal loans.
• No restrictions on how to use the money: Some financial products restrict how you can use your borrowed money. But when you take out a home equity loan, you can use the funds for whatever you need — including paying off your mortgage early.

Cons of a home equity loan

• Home serves as collateral: Home equity loans and home equity lines of credit (HELOCs) are both secured by your property. If you default on these second mortgages, you could lose your home.
• Closing may be expensive: Home equity loans may come with closing costs, though some lenders waive the fees or roll them into the loan. If you have to pay these fees, they’ll add to your borrowing costs.
• Loan amounts are limited: You can typically borrow up to 85% of the equity in your home. So if you have $300,000 in equity, for example, the maximum you could borrow is $255,000. If you haven’t built enough home equity to zero out your mortgage, think about holding off until your home equity increases.

How to use a home equity loan to pay off your mortgage

It’s possible to use a home equity loan to pay off your mortgage, but you’ll want to make sure it’s the right move for you.

After comparing your home equity loan options, make sure that:

1. You can borrow enough to pay off your first mortgage
2. The home equity loan interest rate is lower than the rate on your first mortgage
3. You won’t end up paying more in interest than if you were to ride out your mortgage

Take a look at one example to see how this strategy might work in your favor:

Let’s say your home is worth $400,000. Your mortgage balance is $82,000 with an interest rate of 4% and a monthly mortgage payment of $1,527. You only have five years left on the home loan. If you were to finish out the remaining five years, you’d pay $8,796 in interest.

But say you qualify for an $82,000 home equity loan with no closing costs, an interest rate of 3.25%, and a loan term of five years. The monthly home equity loan payment is about $1,483, and you would pay about $6,954 in interest over the loan term.

In this example, the home equity loan helps you save $44 on your monthly payment and $1,842 in overall interest.

How HELOCs work

Home equity lines of credit, commonly referred to as HELOCs, are different from home equity loans because you get access to a line of credit — similar to a credit card — instead of a lump sum of money.

HELOCs also come with variable interest rates. During the draw period, you can draw from the credit line as much as you need, up to a preset maximum amount. Once the draw period ends, usually after 10 years, you’ll enter a repayment period and pay off your balance.

Homeowners can usually borrow up to 75% to 85% of a home’s appraised value, minus any outstanding home loan balance.

Pros of a HELOC

• Low interest rates: Interest rates on HELOCs are generally lower than what you’d find on a credit card or personal loan because the line of credit is secured. In some cases, HELOC rates even beat home equity loan rates.
• No restrictions on how you can use the money: A HELOC allows you to borrow as much money as you need (up to your credit limit) and you can use the funds for any expenses you have, such as paying off your mortgage or making home renovations.
• Flexible repayment terms: Some lenders only require you to make interest payments during the draw period. There are even fixed-rate HELOC options too, which allow you to lock in a rate on the sum you borrow.

Cons of a HELOC

• Interest rates may increase: Home equity lines of credit come with variable rates, which means your rate can go up or down over time. That makes your monthly mortgage payments unpredictable, and you might end up paying more interest on the HELOC than you would on your first mortgage.
• Home serves as collateral: Like a home equity loan, a home equity line of credit is secured by your house. If you can’t pay back the money, your lender has the right to start foreclosure proceedings, and you could lose your home.
• Overspending: The easy access to cash might be convenient for home upgrades and emergency payments, but if you’re not disciplined, you could be susceptible to spending beyond your means. Make sure you only borrow what you need and can afford to pay back.

Check Out: Here’s What You Need to Get a Home Equity Loan or HELOC

How to use a HELOC to pay off your mortgage

If you want to pay off your first mortgage using a HELOC, it’s important to consider how much you can borrow, whether you’ll save money, and why you’re taking out the line of credit.

Let’s use the home loan example from the previous section: You have a home worth $400,000, and your mortgage balance is $82,000 with an interest rate of 4%. You’re making monthly payments of $1,527 and you have five years remaining on the loan. By finishing out the loan, you’d pay $8,796 in interest.

Now, say you qualify for an $82,000 HELOC with no closing costs and an initial interest rate of 1.99%. Your draw period is five years, and you have a repayment term of 15 years.

Here are the two options you’ll want to compare if you’re looking to use the HELOC to pay off your mortgage:

Repay the HELOC within the draw period

This could be a good option if you want to pay down your debt quickly and save on interest. Your monthly payment would equal about $1,437, and you end up paying just $4,215 in interest over five years.

Compared to your first mortgage, the HELOC saves you $90 on your monthly payment and $4,581 in total interest. Of course, any rate increases will drive up your interest costs — this is why opting for a fixed-rate HELOC is typically a better option.

Pay the minimum during the draw period

If your monthly income recently dropped, you might choose to just make the minimum payment during the draw period.

In the aforementioned example, the minimum interest-only payment is about $136. Once the repayment term starts, the monthly payment rises to $527. Over the entire 20-year HELOC term, you’d pay $21,073 in interest — and that’s without any rate increases.

This option won’t save you money on interest compared to the first mortgage, but it can put breathing room in your budget.

Which option is right for you?

Taking out a home equity loan or HELOC may save you money on interest compared to paying down your first mortgage on schedule. Or, if your budget is tight, replacing your mortgage with a HELOC could help you better afford your home.

But you’ll need to compare the first mortgage against the loan terms you qualify for, including:

• How much you can borrow
• The interest rate
• Closing costs and annual fees
• Whether the rate can increase over time
• How much you’ll pay in interest

If you’ve determined a home equity loan or HELOC won’t work for your situation, you might consider a rate-and-term refinance or a cash-out refinance.

A traditional refinance may help you lower your interest rate and monthly payment, while a cash-out refi allows you to refinance your home and tap your equity for a lump sum of money.