Should you use a cash-out refinance to pay off a HELOC or home equity loan?

In this article:

In most cases, interest rates for home equity loans and lines of credit are higher than those of traditional first mortgages. And home equity financing often comes with a variable interest rate, which can increase over time.

• Replacing your home equity loan and current mortgage with a cash-out refinance may save you money
• Paying off a HELOC with a cash-out refinance could lower your payments
• Cash-out refinancing is more expensive than rate-and-term refinancing, so run the numbers carefully

Verify your new rate (Nov 13th, 2018)

What is a cash-out refinance?

Before diving into the question of using a cash-out refinance to pay off HELOC, let’s get the terms straight.

A cash-out refinance involves replacing your mortgage with a larger one. You receive (usually) a check for the difference, after paying your mortgage costs.

Many choose to spend the money to pay down other debts, start a new enterprise, pay college tuition, boost investment portfolios or cover some unavoidable commitment, such as medical bills. You’ll use some or all of it to pay off your HELOC or home equity loan.

Related: Best uses for your mortgage cash-out refinance

Your equity is the amount by which the current market value of your home exceeds your mortgage balance. But don’t expect to be able to borrow against all of it unless you have a Veterans Administration (VA) loan. Most lenders cap borrowing secured on your home at 80 percent of your property value, though the Federal Housing Administration (FHA) allows 85 percent.

What’s a HELOC?

HELOC is an acronym that stands for home equity line of credit. It’s a form of second mortgage, meaning you’ve put your home up as security for the loan. And you could face foreclosure if you default.

There are many forms of HELOC with varying terms — 15 years is a popular one. The loan will have a “draw” phase, followed by a “repayment” phase.

During that first phase, which might last 10 years, you can borrow as much as you want up to your limit, pay back sums you choose and then reborrow back up to that limit. But all you have to pay during this time is interest on your balance. For instance, for a HELOC at 6 percent with a $25,000 balance, the monthly interest is $125 a month.

Related: Will your HELOC payment skyrocket in 2018?

However, the second, “repayment” phase is much less fun. Suddenly, you can’t borrow on your HELOC any more. And you have to repay the entire balance over the remaining term of the loan. Once your 10-year draw period ends, you might get five years in which to off your balance.

That can hurt once the draw period ends and you have five years to clear that balance. For that $25,000 loan at 6 percent, for example, your monthly payment increases to $483. And that’s assuming that the interest rate doesn’t go up.

Can you use cash-out refinance to pay off HELOC?

You can see where this is going. Can you head off that payment jump by using a cash-out refinance to clear your HELOC? Or to pay off a standard home equity loan, the other common type of second mortgage? The short answer is Yes.

Mortgage prepayment penalties

However, you should check the agreements you signed for your first mortgage and HELOC before you get too excited. One or both of those might contain clauses that impose prepayment penalties. Not all lenders include them but some do.

Usually, these penalties fade away to nothing after a few years. They rarely have much (or any) bite after five years.

HELOC or home equity loan penalties

For HELOCs, these penalties are called early closure fees. And they’re most likely to be troublesome if you only recently signed up for your loan.

Related: How your loan’s features affect your interest rate (and what to do about them)

In short, you’re likely to be fine using a cash-out refinance to pay off HELOC if you didn’t just take out either your first or second mortgage. If one or both are very recent, you need to work out the exact costs and feed them into your calculations. In some cases, they can undermine the economic basis of a refinance.

The impact of mortgage rates

Speaking of the economic basis of a refinance, you need to consider currently available interest rates versus the one you already have. In a rising rate environment, it’s harder to get a lower rate without shortening the term of the loan (from a 30-year to a 15-year, for example) or choosing an ARM loan.

The exception might be if you’re a “better” borrower now than when you originally borrowed: with a higher credit score, more equity or a stronger income / debt picture.

Rates versus payments: what’s your refinancing goal?

Cash-out refinancing is not cheap, and you may not get a lower interest rate than that of your current first mortgage. However, your monthly payment is likely to be lower than that of your mortgage and HELOC payments combined. Spreading out a 5-year repayment schedule over 30 years is likely to accomplish that.

Still, you must make sure your new payments are going to be affordable. So get a rate quote and use The Mortgage Reports payment calculator to get a firm grasp on what you’d face. You need also keep an eye on your total cost of borrowing: all loan charges plus the interest you pay until your home is completely free and clear.

Understand that in the long run, you’re likely to pay more interest by stretching out your home loan repayment, even if you get a lower rate by refinancing. You are trading a lower payment today for a higher cost tomorrow. There is nothing wrong with it as long as you are aware and going into your loan with both eyes open.

Alternatives

Before you commit to a cash-out refinance to pay off HELOC, explore a couple of alternatives. You may be able to refinance the HELOC itself, either to another HELOC or to a home equity loan with a fixed interest rate and payment.

Both these typically have the advantage of lower closing costs and less hassle than a cash-out refinance. But they’ll likely come with higher interest rates. So do the math before you make your choice.

Verify your new rate (Nov 13th, 2018)