If you're a homeowner you might wonder if it's a good idea to dip into your equity using a HELOC. Laura explains what a HELOC is, how to get one, recent tax changes, if you should use one to pay off a primary mortgage faster, and the main pros and cons to consider.
Can You Use a HELOC to Pay Off a Mortgage Faster?
With the rising popularity of HELOCs, many people are using them to pay off other debts. Whether you should use a HELOC to pay off your primary mortgage faster is a hotly debated topic.
The idea is that if your HELOC has a lower interest rate than your mortgage, you could save money by spending a HELOC to pay down your primary mortgage faster. This is basically refinancing your mortgage with a HELOC.
Problem is, drawing down your HELOC is risky because it’s typically an adjustable-rate product, which means you could have substantially higher interest rates and monthly payments. Also, you’d have to have a large amount of home equity in order to get a HELOC big enough to really make a dent in your primary mortgage.
If, and only if, your finances are in great shape, with plenty of savings and no debt, you may be in a position to pay off your mortgage early. But instead of using a HELOC to pay down your mortgage, I’d recommend that you just pay extra toward the principal each month.
You could also refinance your mortgage for a shorter, fixed-rate loan, such as a 10- or 15-year term. But you can accomplish the same thing and avoid the cost of doing a refinance by setting up your own schedule and just paying extra each month. Use the Excel Mortgage Loan Calculator template to easily see how much faster you can pay off a mortgage by making additional lump sum or ongoing payments.
Unless you’re saving at least 10% of your gross income for retirement, have an ample emergency fund, and zero debt (besides your mortgage), you shouldn’t even be thinking about paying down your mortgage early.
But if you are a good candidate to use a HELOC to refinance your mortgage, ask your lender if it’s possible to get a rate lock. That would make all or a portion of your HELOC a fixed-rate loan, with a set monthly payment. And by the way, locking your HELOC rate is also a good idea when interest rates are moving up.
While it might be awfully convenient to tap your home equity, don’t use it as a band-aid if you’re having a financial hardship.
Using a fixed, lower-rate HELOC to pay off a higher-rate primary mortgage could make sense, but it’s not a feasible or wise solution for most people. Always discuss your plans for using a HELOC with potential lenders and be clear about upfront fees or prepayment penalties.
4 Pros of Getting a HELOC
In addition to the potential tax deduction I covered, there are other benefits of a HELOC. One is that using your home equity for renovations could increase the market value of your home, helping you increase your net worth.
Here are four main pros for getting a HELOC:
- You have the flexibility to tap a line of credit whenever you need it.
- Interest is charged only for amounts you use.
- Adjustable interest rates can be lower than fixed loan rates (but not always).
- You can spend it on anything you like.
4 Cons of Getting a HELOC
Now, let’s cover the downsides of a HELOC. The biggest con is that borrowing against your home puts you at risk. Since your property is collateral for a HELOC, if you can’t repay it, the lender can force a home sale to satisfy your debt.
Also, if you take a HELOC and the value of your home drops due to local market conditions or an economic downtown, you may have to come up with cash to repay it. If you qualify for a HELOC, here are four cons to consider:
- You must pay interest on amounts borrowed.
- Lenders charge fees and closing costs to originate the loan.
- Adjustable rates mean your minimum monthly payment can go up significantly, depending on the laws in your state.
- Missing payments can hurt your credit.
Applying for a HELOC can be a sensible and convenient way to cash out part of your home’s equity. Just remember that if you spend it on something that decreases in value or has no value over the long term, such as consumer credit card debt or a vehicle, your net worth can decrease.
While it might be awfully convenient to tap your home equity, don’t use it as a band-aid if you’re having a financial hardship. Carefully consider whether decreasing your equity and paying interest on a HELOC is worth it. If it doesn’t bring you closer to achieving your financial goals, it probably isn’t.
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