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You may have heard about the home equity line of credit (HELOC) strategy to pay off your mortgage early. This unconventional idea has become more popular in some personal finance circles over the years. While the idea is simple enough, in theory, there’s plenty you must know about the strategy before you commit to this method for paying off your mortgage.
We’ll make sense of what this HELOC payoff strategy is all about so that you know what you’re getting into. There are many pros and cons you must consider upfront, especially as interest rates continue to rise.
What’s the HELOC Payoff Strategy?
Before we look at the HELOC strategy for paying off your mortgage early, we must first make sense of the concept. A HELOC is a revolving line of credit that’s essentially a second mortgage on your home. You’re borrowing money against your home’s equity and can often borrow up to 80% of your home’s value with a HELOC. The equity is the difference between your mortgage’s remaining balance and the home’s current market value.
You can then use this HELOC like a credit card because you can decide how much of the balance you want to spend during the draw period up until the specified limit, which will depend on how much your home has gone up in value. You only have to pay back what you use with a HELOC.
A HELOC differs from a home equity loan because it’s similar to a credit card, while a home equity loan is a lump sum with a fixed interest rate.
A HELOC has two periods that you have to know about:
- The draw period – This is usually about five to 10 years, and the borrower can use the available credit in the HELOC, then make monthly payments that only consist of the interest.
- Payback period – During this period, the borrower can’t access any more funds and must make interest and principal payments.
An Unconventional Option
The HELOC payoff strategy is an alternative and an unconventional option for you to consider. Since you can use your HELOC any way you wish, you can use it to pay off your remaining mortgage balance. Many folks believe in it because you can reduce your monthly payments while cutting the total interest cost on your loan.
The goal is for the homeowner to get approved for a HELOC with a credit limit equal to the remaining balance of the mortgage. If you owe another $100,000 on your mortgage, the aim is to land a credit limit of $100,000 so that you can wipe out your entire mortgage with this money. Then you would make the interest payments only until you reach the payback period. If you could land a lower interest rate with your HELOC compared to your fixed mortgage, then the HELOC strategy makes sense.
This strategy is truly just another form of refinancing since you can reduce your interest rate without dealing with the closing costs traditionally associated with refinancing your home mortgage.
What Are the Advantages of the HELOC Strategy?
The most significant benefit of a HELOC is the flexibility that comes with it since you can access money you can use in any way you see fit. For example, you could use HELOC to pay off your mortgage, pay off some of your other debt, and even renovate your home. Some folks have used HELOCs to renovate their homes to sell them for a higher price.
Low To No Closing Costs and Lower Interest Rates
When you get a HELOC, you don’t have to go through the traditional refinancing process you would have to with your primary mortgage. Some lenders also offer no-closing-cost HELOCs.
Additionally, depending on when you locked in your home mortgage, you could use a HELOC to tap into a much lower interest rate for your payments.
Related: How to Find the Best Mortgage Rates
What Are the Disadvantages?
While the HELOC payoff strategy may seem simple enough, there’s more to this theory that you must consider.
Variable Interest Rates Could Go Up
Since your HELOC comes with a variable rate, while your home mortgage is a fixed rate, you could find yourself in a scenario where your HELOC costs you more than your original mortgage. With variable rates on the rise right now, you could find yourself spending more money on interest for your HELOC than you planned.
Lack of Discipline
The harsh reality is that many can’t be trusted with access to what’s essentially a credit card with a high limit. In the perfect world, you would use the HELOC strategy to pay off your mortgage early. But in reality, you could use this as another credit card for everyday purchases when you get tempted to buy something.
Your Life Situation Could Change
Apart from the fact that it will take discipline to manage the complexity of the HELOC strategy, it will also be challenging to keep it going during times of financial stress. As we’ve seen with all of the economic uncertainty lately, anything can happen to your financial situation with the possibility of a recession looming over us.
You’re Replacing One Form of Debt With Another
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 even greater. It will take incredible discipline for the several years it will take to pay off the mortgage to avoid landing in a worse financial situation.
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 potential to go in an unexpected direction.
Take this, for example:
After five years of using the HELOC strategy, your $200,000 mortgage is paid down to $100,000. But you now have $100,000 in HELOC debt with a higher variable rate than your previous fixed rate due to macroeconomic factors. You won’t be that far ahead aside from saving a little bit of money on interest at points.
We also have to remind you that in today’s climate with rising interest rates, you may not want to go through the hassle of applying for a HELOC when you could focus on making additional payments on your mortgage.
Let’s say you’re not confident in the HELOC strategy for paying off your mortgage early. What can you do? Here are a few alternative options.
- Refinance to a lower rate – Refinancing an existing mortgage to a lower interest rate can save a lot of money if you can find a lower rate.
- Make extra principal payments – You can pay a certain amount of extra principal to your regular monthly payments. It could be $100 per month or 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 on 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 an entire decade off the loan.
- Apply for a home equity loan – If you take out a home equity loan, you get a lump sum with a fixed rate, so you won’t have to worry about your monthly payments changing.
Remember that paying off a mortgage is a long-term process that will take many years. For that reason, the method you choose must fit comfortably within your personality and your financial situation. Just because a financial strategy works for one person online doesn’t mean that this is the right move for you and your family.
The Final Word on the HELOC Strategy
Deciding if you should use this strategy will depend on your personal situation and what you’re comfortable with. There are many ways to pay off your mortgage early if your goal is to become debt-free. While the HELOC payoff strategy seems trendy these days, it’s not your only option.
Before you go with the HELOC strategy to pay off your mortgage early, you must be aware of what you’re signing up for. We can’t ignore what’s happening with the economy right now, with soaring inflation and rising interest rates. With interest rates rapidly rising, you could find yourself in a situation where you replaced a fixed mortgage payment with a variable interest rate that’s constantly fluctuating.