Can You Refinance a Mortgage With a HELOC?

Using a Home Equity Line of Credit (HELOC) to pay off an existing mortgage is a financial maneuver homeowners can consider. Understanding the mechanics of a HELOC and the implications of such a strategy is important for homeowners evaluating their options.

Understanding HELOCs

A Home Equity Line of Credit (HELOC) functions as a revolving line of credit that uses a homeowner’s property as collateral. Unlike a traditional home equity loan, which provides a single lump sum, a HELOC allows funds to be drawn as needed, up to a predetermined credit limit. This structure is similar to a credit card, where borrowers can access funds, repay them, and then draw again during a specified period.

HELOCs feature a variable interest rate, which can fluctuate based on market conditions. The HELOC structure is divided into two phases: a draw period and a repayment period. During the draw period, which commonly lasts 5 to 10 years, borrowers can access funds and make interest-only payments on the amount borrowed. Once the draw period concludes, the repayment period begins, generally lasting 10 to 20 years, during which principal and interest payments are required, and no new funds can be drawn.

The credit limit for a HELOC is determined by the amount of equity a homeowner has in their property. Equity represents the difference between the home’s market value and the outstanding mortgage balance. Lenders permit borrowing up to 80% or 85% of the home’s value, including any existing mortgage debt, which is assessed through a loan-to-value (LTV) or combined loan-to-value (CLTV) ratio.

Executing the Mortgage Payoff with a HELOC

Using a HELOC to pay off an existing first mortgage involves several steps. The process begins with obtaining a HELOC, which is established as a second lien on the property, meaning the original mortgage maintains its primary lien position. Once the HELOC is approved, funds are drawn from this line of credit.

These drawn funds are applied to pay off the primary mortgage. After the original mortgage is satisfied, the financial structure on the property changes. The initial mortgage lien is removed, and the HELOC, previously a second lien, becomes the primary encumbrance on the home.

It is important to confirm the payoff with the original mortgage lender and ensure the lien is released from the property records. This step involves the lender filing a release of mortgage document with the county recorder’s office. This recording ensures the property’s title is clear of the prior mortgage debt.

Key Financial Implications

Replacing a fixed-rate mortgage with a variable-rate HELOC introduces several financial considerations. A characteristic of HELOCs is their variable interest rate, meaning monthly payments can change with market fluctuations. This contrasts with the predictability of a fixed-rate mortgage, where the interest rate remains constant throughout the loan term.

The payment structure of a HELOC also differs from a traditional mortgage. During the initial draw period, borrowers have the option to make interest-only payments. This can result in lower monthly payments initially, but once the draw period ends and the repayment period begins, payments will include both principal and interest, leading to a significant increase in the monthly obligation.

Managing this debt requires income stability, especially given the potential for increased monthly payments in the repayment phase. The deductibility of interest on a HELOC also has rules. Interest paid on a HELOC is tax-deductible only if the funds are used to buy, build, or substantially improve the home that secures the loan. If the funds are used for other purposes, such as paying off a mortgage, the interest may not be deductible.

Using a HELOC also impacts a homeowner’s available equity. Drawing down equity to pay off a mortgage reduces the homeowner’s equity and can affect their financial flexibility for future needs. While the mortgage debt is transferred, the total amount of secured debt against the property may remain the same or increase, depending on the HELOC limit.

Regulatory and Procedural Aspects

The process of obtaining a HELOC involves several steps. Homeowners must submit an application that includes personal information, such as Social Security number and employment history. Lenders will evaluate creditworthiness, including reviewing credit scores (a score above 680 is favorable) and assessing debt-to-income ratios. Proof of income, such as recent pay stubs or tax returns, is also required to verify repayment capacity.

A home appraisal is a step to determine the property’s market value and available home equity. This valuation helps the lender establish the credit limit for the HELOC. While some lenders may offer no-appraisal options, a full appraisal is typical.

HELOCs involve closing costs, similar to other mortgage products. These costs can range from 2% to 5% of the total line of credit and may include fees for appraisal, origination, and title services. Some lenders may offer to cover these costs or roll them into the loan, but this can be reflected in the interest rate. The HELOC, once approved, is recorded as a lien against the property. If it pays off the first mortgage, it takes that primary lien position.