Refinancing two loans into one
If you have a home equity line of credit (HELOC) or a home equity loan, you’ve probably considered refinancing it into one loan using a cash-out refinance.
You’re not alone.
According to Freddie Mac, more than $200 billion in home equity has been taken out to consolidate second mortgages this decade alone.
Mortgage rates are low, and it could be a good time to trade in that home equity loan for a new low fixed rate. Here’s how.
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Can you use cash-out refinance to pay off a HELOC?
Yes. In fact, thousands of homeowners pay off HELOCs with cash-out refinancing each year.
Many choose refinancing as a HELOC repayment option because they are worried that their variable interest rates will suddenly skyrocket, since it’s probably based on the current prime rate.
However, the prime rate has been at historic low levels since the early 2000s, and it’s likely to stay relatively low for years to come.
Additionally, many homeowners are close to their HELOC turning 10, at which point they transition from an interest-only payment to a fully amortized one. Plus, the rate might go up at that point too. It’s not uncommon for the payment to double.
The potential solution? A cash-out refinance.
Lenders have no restrictions on how you can use proceeds from a cash-out refinance.
Luckily, mortgage lenders have no restrictions on how you can use proceeds from a cash-out refinance. That means you can use the proceeds to pay off a HELOC just as easily as you can stick that lump sum of cash into your bank account.
At closing, your escrow company simply cuts a final payment to your HELOC lender, (assuming you have enough equity) and you never have to make two monthly mortgage payments again.
Consider paying off a HELOC with rate-and-term refinancing
Paying off a second mortgage is sometimes considered a “rate-and-term” refinance rather than a cash-out refi. This can be an advantageous repayment option, since rate-and-term refis come with lower rates and fewer restrictions.
Here are the requirements if you want to pay off a HELOC with a rate-and-term refinance instead of a cash-out loan:
- The new loan will be a conventional/conforming loan issued by a Fannie Mae- or Freddie Mac-approved lender
- The HELOC or home equity loan was used to purchase the property
- The entire HELOC loan balance was used for the purchase
- No additional draws have been made against the HELOC/second mortgage
- You can provide a settlement/closing statement for the home purchase
In short, you may qualify for the rate-and-term status if you used an 80-10-10 piggyback loan. The only reason you have a HELOC is that you financed the original home purchase.
You might be wondering if you’ll save money by refinancing two mortgages into one loan.
Figure that out in three steps:
- Calculate the interest-only payments on your existing HELOC with this formula: (Current HELOC balance) X (interest rate displayed as a decimal [i.e. 5.25% = 0.0525]) / 12 — For instance, $50,000 X 0.0525 / 12 = $218.75/mo.
- Add this amount to your current first mortgage payment including taxes and insurance
- Compare that number to your new full payment by plugging in your refinance numbers at this mortgage calculator (Enter remaining equity after the refi into the Down Payment field)
Now you know whether you’ll save money by consolidating your HELOC into one new fixed-rate loan.
While these calculations will tell you if you’re saving money, keep in mind that once the interest-only period ends and rate adjustments have been applied, the payment on your HELOC may also increase.
Risks with cash-out refinancing your first and second mortgages
Using a cash-out refinance to pay off a second mortgage doesn’t come without risks.
Mortgage prepayment penalties
You should check the loan terms you agreed to for both your first mortgage and HELOC before you get too excited about cash-out refinancing. One or both of those loans might contain clauses that impose prepayment penalties. NMost lenders don’t 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.
Check with your mortgage advisor to help you understand the cost benefit if, and when, there are prepayment penalties.
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.
In short, you’re likely to be fine using a cash-out refinance to pay off a 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.
Impact of mortgage rates
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 adjustable-rate loan (ARM).
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.
You also need to keep an eye on your total cost of borrowing: All loan charges, such as origination fees, plus the interest payments you make on the life of your loan.
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: Refinance into a second HELOC or home a equity loan
Before you commit to paying off a HELOC with a cash-out refinance, 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 HELOC repayment options 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.
How HELOC repayment works
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 types of HELOCs with varying loan terms — 15 years is a popular one. The loan will have a draw period, followed by a repayment period.
During that first draw phase, which might last 10 years, you can borrow as much against your credit line as you want, up to your limit. You pay back sums you choose, and you can reborrow again, up to that limit, as long as you are in the draw period.
In this way, a HELOC is similar to a credit card. Except, instead of paying down a credit card’s principal balance or making minimum payments each month, all you have to pay during a HELOC’s draw period is interest on your balance. For instance, for a HELOC at 6% with a $25,000 balance, the monthly interest payments are $125 a month.
At the end of the draw period, your credit line’s repayment term begins. Suddenly, you can’t borrow on your HELOC any more. And you have to repay the entire loan amount over the remaining term of the loan. Once your 10-year draw period ends, you might get five years in which to pay off your loan balance.
Many borrowers find their HELOC repayment period challenging financially, especially with only a 5-year repayment term to pay off the entire loan amount. For that $25,000 loan at 6%, for example, your monthly loan payment increases to $483. That’s assuming that the interest rate doesn’t go up.
Paying off HELOCs with a cash-out refi FAQ
While it depends on the loan terms of your HELOC, many borrowers need approval from their second mortgage lenders before they are allowed to refinance their first mortgage loans. If your HELOC lender does not agree, then you will need to pay off any outstanding balances on your HELOC before refinancing.
A cash-out refinance involves replacing your current mortgage with a larger one. You receive a lump sum of cash for the difference, after paying your mortgage costs. Many choose to use the increased cash flow to start a new enterprise, pay college tuition, boost investment portfolios, cover medical bills, fund home improvements and renovations, or to pay down other debts such as outstanding balances on credit cards or personal loans.
Your home equity is the amount by which the current market value of your home exceeds your current loan amount. But don’t expect to be able to borrow against your entire home’s equity unless you have a Veterans Administration (VA) loan. Most lenders cap borrowing secured on your home at 80% of your property value, though the Federal Housing Administration allows 85% on FHA loans.
Apply for your HELOC consolidation loan
If you have decent equity and credit, using a cash-out refinance to consolidate a HELOC is probably easier than you think.
Shop current rates with top lenders and get started on your goal to finally retire that home equity loan.