Is your HELOC nearing its 10th anniversary? If you're approaching the end of your draw period, you might be thinking about refinancing it to avoid a financial hit or maintain the financial flexibility it provides.
That’s because many home equity lines of credit, better known as HELOCs, leave their draw period and enter their repayment phase after 10 years. If your HELOC is at this point, and you owe money on it, your monthly payments might jump, by a sizable amount, as its repayment period begins. As your draw period ends, you’ll also lose access to the quick cash that a HELOC provides, meaning that you won’t be able to tap the equity in your home for a kitchen remodel, your children’s college tuition or paying down your higher-interest-rate credit cards.
You can avoid this by refinancing your HELOC, either into a new HELOC or by combining it with your primary mortgage into one new primary loan. You might also take out a home equity loan and use the proceeds from that to pay off your HELOC.
But before you decide which of these approaches is best, it’s important to understand how HELOCs work and how they differ from other mortgage loans.
HELOCs vs. home equity loans
A HELOC is similar in many ways to a standard home equity loan. Both allow you to borrow against the equity in your home. Say your home is worth $200,000 and you owe $120,000 on your mortgage. You now have $80,000 worth of equity.
A lender, then, might approve you for a HELOC or home equity loan for, say, $50,000.
The big difference? With a home equity loan, you'll receive your money in a lump sum. You then pay it back each month with interest until you pay off what you borrow. It's like paying off your primary mortgage.
A HELOC, though, is more like a credit card, one with a maximum credit limit based on your equity. If you have $70,000 worth of equity, a lender might approve you for a HELOC with a maximum borrow limit of $60,000.
With a HELOC, you only borrow money when you need it. You might want to renovate your kitchen. To pay for it, you could borrow $20,000 against your $60,000 HELOC. That leaves you with $40,000 left to borrow, if you’d like.
The phases of HELOCs
HELOCs come with two set phases. First, there's the draw phase. During this period, which usually lasts up to 10 years, you can withdraw funds as you need them. Some HELOCs are interest-only during this period, meaning you only make interest payments on what you borrow, never paying down your principal. Other HELOCs have a draw period in which you can pay off both your interest and principal balance, as you do with most primary mortgages.
When your draw period ends, your loan moves into the repayment period. This period can last up to 20 years. During it, you'll pay back your outstanding principal balance and any interest you owe. If you had been paying only interest during the draw period, your monthly payments can jump significantly during repayment.
This is one reason why some homeowners might choose to refinance a HELOC before it enters the repayment phase: They don't want to make those higher monthly payments in addition to the payments they are making each month on their primary mortgages.
Borrowers worried about higher payments do have options. They can refinance their existing HELOC to a new one and start the draw period, and the interest-only payments that come with it, all over again. They can apply for a home equity loan with a fixed interest rate and use the cash from that loan to pay off their HELOC. Or they can refinance both their HELOC and their existing primary mortgage into one loan.
Other homeowners, though, choose to refinance their HELOCs for a different reason: cash-flow.
These borrowers want to retain access to the credit line available with a HELOC. This way they can tap their home's equity easily if they need to consolidate credit card debt with high interest rates or take on a pricey home renovation.
These owners, then, aren’t interested in consolidating their HELOCs and primary mortgages into one fixed-rate loan. They also aren’t interested in taking out a home equity loan to pay off their HELOC’s balance. They want the credit line that comes with a HELOC so that they have more flexibility to borrow money when they need it, whether planned or for unexpected expenses.
Eric Wilson, director of operations for Better Mortgage in New York City, said that this approach isn't unusual.
"People view the line of credit as a nice option," Wilson said. "They want to keep that credit line available to them. They don't have to use it, but it is a nice option to have if you do need it."
By refinancing to a new HELOC, these owners are essentially extending their draw period and pushing off the repayment phase of their HELOCs.
The advantage of this is the flexibility. Owners have easy access to cash. The disadvantage? They are only putting off the inevitable. They will eventually have to pay back what they borrowed on their HELOCs. They can’t refinance indefinitely, and the more they borrow, the more they’ll have to eventually pay back.
Avoiding higher payments
Skyler Wallace, chief executive officer of Joplin, Missouri-based mortgage education company Lendly, said that owners who are ready to replace their HELOCs with home equity loans are in a good position today.
That's because mortgage interest rates, even though they have risen, are still at historic lows. As an example, U.S. Bank as of June 23 was offering a 10-year home equity loan from $50,000 to $250,000 with an APR of 4.89 percent.
Home equity loans also come with the advantage of a fixed interest rate. HELOCs usually come with adjustable rates that can fluctuate over time. With a home equity loan, borrowers have more certainty over what their payment will be each month because their interest rate will never change.
"You can still get pretty competitive interest rates," Wallace said. "If you are sitting there with a HELOC that you want to refinance, your better bet is to get that locked in at a competitive rate for a long term. There is no guarantee on how rates will move, but the trend is that they are going up."
The downside here? Borrowers will lose the line of credit, and flexibility, that comes with a HELOC.
"If you have no further need for the line of credit and are focused on paying it back, this can be a great option," said Kevin Michels, financial planner with Draper, Utah-based Medicus Wealth Planning. "Especially with interest rates most likely rising in the future, refinancing to a fixed-rate loan can save you a substantial amount in interest."
Refinancing a primary mortgage and a HELOC into one fixed-rate loan also comes with challenges. Again, homeowners who successfully do this will lose the line of credit that comes with a HELOC. Many won’t even be able to take this approach depending on how much equity they have in their homes.
Lenders usually won’t approve refinance requests unless homeowners have built up at least 20 percent equity in their homes. Say you owe $150,000 on your primary mortgage and $10,000 on your HELOC, for a total of $160,000. If your home is only worth $165,000, you’ll have far less than the 20 percent equity needed for this kind of refinance.