Can You Use a HELOC to Pay Off Your Mortgage?

Homeowners often consider various financial strategies to manage mortgage debt, including utilizing a Home Equity Line of Credit (HELOC). This article explores the nature of HELOCs, the practical steps involved in using one to pay off a mortgage, and the financial implications of this decision.

Understanding a Home Equity Line of Credit

A Home Equity Line of Credit (HELOC) functions as a revolving line of credit secured by the equity in a homeowner’s property. It operates similarly to a credit card, allowing borrowers to access funds as needed, up to an approved credit limit. This financing represents a second mortgage or lien placed on the property.

HELOCs typically feature variable interest rates, meaning the rate can fluctuate based on market conditions, often tied to a benchmark like the prime rate. A HELOC is structured with two distinct phases: a “draw period” and a “repayment period.” During the draw period, which lasts between five and ten years, borrowers can access funds, often making interest-only payments on the amount borrowed.

Following the draw period, the HELOC transitions into the repayment period, typically lasting 10 to 20 years, during which no further funds can be drawn. During this phase, borrowers must make payments that cover both principal and accrued interest on the outstanding balance. The available credit limit is determined by factors such as the home’s appraised value, the outstanding balance of the existing mortgage, the borrower’s credit score, and their debt-to-income ratio. Lenders generally allow borrowing up to 80% to 85% of the home’s combined loan-to-value (CLTV), which includes both the existing mortgage and the new HELOC.

The Mechanics of Using a HELOC for Mortgage Payoff

The process of using a HELOC to pay off an existing mortgage involves a direct transfer of debt, rather than a reduction in the total amount owed. Once a homeowner is approved for a HELOC, they can draw funds from it. These drawn funds are then used to pay off the remaining balance of the primary mortgage.

After the primary mortgage is satisfied, the HELOC becomes the primary debt secured by the home. The homeowner’s financial obligation shifts to making payments on the HELOC according to its terms. This strategy changes the debt’s nature, moving from a traditional mortgage to a more flexible line of credit. While the original mortgage account is closed, the underlying debt against the home remains under the HELOC agreement.

Key Financial Implications

Replacing a traditional mortgage with a HELOC introduces several financial changes that homeowners should understand. A primary difference lies in the interest rate structure. Many traditional mortgages feature fixed interest rates, providing predictable monthly payments over the loan term. In contrast, most HELOCs come with variable interest rates, meaning monthly payments can fluctuate based on market rate changes. This variability can lead to higher payments if interest rates rise, potentially increasing the overall cost of the debt over time.

Repayment terms also differ significantly. While mortgages typically have long, fixed repayment schedules (e.g., 15 or 30 years), HELOCs begin with a draw period where interest-only payments are often permitted. After this initial period, the HELOC enters a repayment phase where both principal and interest payments are required, often leading to a substantial increase in monthly obligations, sometimes referred to as payment shock. The overall repayment term for a HELOC is generally shorter than a traditional 30-year fixed-rate mortgage.

Regarding tax deductibility, the rules for HELOC interest differ from those for primary mortgage interest. Under current IRS guidelines, interest paid on a HELOC is generally deductible only if the funds are used to buy, build, or substantially improve the home that secures the loan. Using HELOC funds for other purposes, such as debt consolidation or personal expenses, typically renders the interest non-deductible for federal income tax purposes. The deductibility is also subject to dollar limitations, with interest on up to $750,000 of combined mortgage debt (including the HELOC) being deductible for joint filers, provided the funds meet the home improvement criteria. Homeowners must itemize their deductions to claim this interest.

Other Debt Management Strategies

Beyond using a HELOC, homeowners have other strategies for managing or accelerating mortgage debt payoff. Traditional mortgage refinancing is a common option, which can take two main forms. A “rate-and-term” refinance replaces the existing mortgage with a new one, potentially with a lower interest rate or a different loan term, without extracting equity.

Alternatively, a “cash-out refinance” allows homeowners to replace their current mortgage with a larger loan, receiving the difference in cash. This new, larger mortgage comes with new terms and a single monthly payment, and can be used for various purposes. Cash-out refinances involve closing costs similar to an original mortgage.

Another strategy involves making accelerated mortgage payments. This can include making bi-weekly payments, which results in an extra full month’s payment toward the principal each year, or simply making additional principal payments. These extra payments directly reduce the principal balance, which in turn reduces the total interest paid over the life of the loan and shortens the repayment period. This method can lead to significant interest savings and faster equity building.