There’s a new strategy floating around the personal finance world: paying off your mortgage faster with a home equity line of credit, commonly known as a HELOC. The strategy alleges that you can pay off your mortgage in just a few years.
Will it work?
On paper it’s brilliant, but I think most of us easily recognize that paper theories don’t always work in the real world. On closer inspection, the HELOC method looks to be more of a myth than anything else.
But let’s take a look at the strategy and consider the likelihood of it succeeding.
The “Cliff’s Notes” Version of the Strategy
The “method” of paying off your mortgage early using a HELOC is more than a little complicated. You can read the full version of the strategy here, but here’s a summary of how it works:
- You must have a positive cash flow—that is, your monthly income exceeds your expenses—the more the better.
- In select months, you put your entire paycheck towards your mortgage.
- You need a credit card, one that will give you “free money” (a grace period) for up to 45 days.
- In the months when you put your entire paycheck towards your mortgage, you put the rest of your expenses on your credit card.
- You add a HELOC to your home, preferably one with a debit card.
- After the end of the credit card grace period, you transfer your entire credit card balance to the HELOC.
- With your next paycheck, you pay off your HELOC balance, instead of your mortgage.
- The next paycheck—after the one that pays off the HELOC—is once again applied to your mortgage.
- Repeat the cycle again and again.
Confused? Let’s work out an example.
Say you have a $200,000 mortgage, and your net paycheck is $5,000 per month. One month, you apply your whole paycheck to the mortgage. This immediately lowers the mortgage balance to $195,000. That month, you pay your non-housing living expenses, say $2,000, using your credit card.
Then, you pay your mortgage payment, say $1,000, using your HELOC. You also pay your credit card balance with your HELOC. At the end of the month, you owe $3,000 on the HELOC and $195,000 on the mortgage, but your credit card has a zero balance.
The next month, your $5,000 paycheck goes to paying $1,000 for the mortgage payment and $2,000 for living expenses. The remaining $2,000 reducing the HELOC to $1,000.
In the third month, your $5,000 paycheck goes to paying $1,000 for the mortgage payment, $2,000 for living expenses, and $1,000 to zero-out the HELOC.
That leaves you with an extra $1,000, which you carry over to the fourth month. And in the fourth month, you repeat the original cycle of paying your entire $5,000 paycheck toward the mortgage, lowering it to $190,000.
If you are successful in managing this strategy, you should be able to manage four $5,000 payments toward your mortgage each year, above and beyond your regular monthly mortgage payments. That means paying an extra $20,000 of mortgage principal each year.
At that rate, your mortgage will be paid in full after substantially less than 10 years (remembering that the regular mortgage payments that you are continuing to make will also reduce the mortgage balance in increasing increments).
It looks like a brilliant plan, but why is this method unlikely to work?
The Strategy is Too Complex to Be Workable
In general, the best financial strategies are the ones that are most simple. Simplicity is the basic concept behind dollar-cost averaging and investing in index funds. Simple means that you don’t have to think about it, or struggle to make it happen—and that’s exactly what it takes to make it work.
The HELOC strategy is anything but simple. You’re essentially setting up a scheme based on debt. This scheme is used not only to pay off your mortgage, but also to manage your entire financial situation. It means that you’re constantly juggling between a credit card and a HELOC, while putting all of your extra money into your first mortgage.
It Will Take More Discipline Than Most People Have
Apart from the fact that it will take discipline to manage the complexity of the HELOC strategy, it will also be very difficult to keep it going during times of financial stress. And you can bet that such times will develop well before your first mortgage is paid off.
For example, the loss of a job will put a hold on the entire strategy. Depending on where you are in the cycle when that last paycheck comes in, you could get stuck with extra debt, too. And if your new job pays less, you may not be able to resume the practice.
In addition, you may get sidetracked by personal factors. For example, since you will be making liberal use of both a credit card and your HELOC, the temptation will be great to use both lines for unrelated purposes.
Using debt as part of any strategy is like playing with fire. That’s because as you become more comfortable using debt, the possibility of abusing it becomes ever greater. It will take incredible discipline for the several years that it will take to pay off the mortgage to avoid landing in a worse financial situation.
You’re Replacing One Form of Debt With Another
The HELOC strategy is at its heart a debt strategy. You’re using a credit card and a HELOC to pay off your mortgage. In the short run at least, that means replacing long-term debt with short-term debt.
The only way to truly get out of debt is by paying it off out of your income or other assets. Using debt to pay off other debt has the real potential to go in an unexpected direction. For example, if after five years of using strategy your $200,000 mortgage is paid down to $100,000, but you now have $100,000 in credit card and HELOC debt, you will have accomplished nothing constructive.
The Strategy is Unlikely to Work Quickly
Like so many other strategies that make miraculous claims, it’s unlikely that you’ll pay off your mortgage in just a few years. First, step back and consider the implications of paying an extra $20,000 per year into your mortgage until it’s paid off. How long will you be able to make that effort?
What happens if along the way you decide you want start a business, or you incur huge medical costs, or you find yourself needing to direct a large amount of your income into taking care of a stricken family member?
The HELOC strategy will have to be abandoned. It’s called life, and it has a way of getting in the way of high-minded plans, especially big ones.
A strategy that requires this amount of money and level of discipline will have to be completed in a few short years, otherwise you will likely tire of the effort. For example, if you’re only able to apply a single monthly paycheck to your mortgage each year, the plan you were hoping would be completed in say eight years, may take more than 20.
HELOCs Are Variable Rate Loans
Using a HELOC to pay off your first mortgage is an unequal exchange. This is because HELOCs have variable rates, while first mortgages usually have a fixed rate. You may be exchanging a fixed rate of 3.something or 4.something, for a variable rate HELOC that could conceivably jump into double digits in a rising interest rate environment.
This will be a serious problem if you’re unable to maintain strict control over your use of the HELOC for the intended purpose only. Not everyone can manage that.
HELOC Lines Can Be Frozen By the Bank
Back in the financial meltdown after 2007, many banks took to freezing HELOCs. They’re revolving lines of credit, so banks are within their rights to do that even if you have been faithfully making payments. That could leave you with a debt obligation that needs to be serviced, but no ability to tap the line further to continue your HELOC strategy.
Don’t be so sure that HELOC freezes won’t happen again in the future. Whatever has happened in the past is very likely to be repeated. And if your strategy for paying off your mortgage relies on a HELOC, your bank could put a sudden end to your effort.
There Are Better Ways to Pay Off Your Mortgage Early
There are less complicated ways to pay off your mortgage early, and they will generally give you more control over the process.
Make extra principal payments. You can choose to pay a certain amount of extra principal to your regular monthly payments. It could be $100 per month, or be something less formal, like paying an extra $1,000 each year. Not only will this reduce the term of your mortgage, but it will also give you complete control of the process along the way. You can make extra payments either higher or lower, depending upon your financial situation at the time.
Make one extra payment each year. By making just one extra payment per year, you can reduce a 30 year mortgage down to 26 years. This is the same effect as a biweekly mortgage payment arrangement, since a biweekly mortgage effectively creates 13 payments per year.
Pay your mortgage based on a shorter term. If you have a 30-year mortgage, you can make payments based on a 20-year term, chopping a full decade off the loan.
Create a “sinking fund.” This is actually a concept from the business world. Companies often set up what are known as sinking funds for the purpose of retiring specific debts. It’s a matter of adding money to a dedicated savings account, until the balance is sufficient to pay off the loan completely. You can do the same thing to pay off your mortgage. It has the advantage of giving you control of the money until you’re ready to completely pay off the mortgage.
Keep in mind that paying off a mortgage is a long-term process, one that will take many years. For that reason, the method that you choose must fit comfortably within both your personality and your financial situation.
And the HELOC method? It’s interesting, I’m sure you’ll agree. But it’s not likely to work for most people. And for some, it could turn out to be a disaster.