Should you refinance into a HELOC?

Hand with pen signing mortgage

If you have good credit and a lot of equity built up in your home, refinancing with a home equity line of credit could be a fast, cheap and easy way to get out from under an expensive mortgage.

You’ll avoid the high cost and hassle of a traditional refi while enjoying a lower interest rate and smaller, more flexible monthly payments.

But there are several things to consider before you take such a seemingly easy step.

Refinancing into a HELOC isn't for everyone.

The best candidates have at least 60% equity in their homes and a relatively small balance on their existing mortgage -- no more than $50,000 to $100,000.

That gives you the best chance of qualifying for a HELOC and weathering the most serious risk associated with this kind of financing -- big and fast changes in the interest rate and minimum monthly payments.

The advantages of refinancing with a HELOC

Replacing one traditional mortgage with another can be a slow and expensive process.

Application fees and closing costs run into the thousands of dollars. You’ll need to produce a ton of tax returns, pay stubs and bank statements.

Knowing the right time to lock in your rate can be nerve-wracking and it's not uncommon for the process to take two or three months.

With a HELOC, up-front costs are rarely more than a few hundred dollars. Many banks and credit unions charge no application or closing fees at all.

The underwriting process doesn’t involve a lot of paperwork and can be completed in a few weeks.

The best HELOC rates -- at least the current rates -- are often lower than you'll find on the best 15- or 30-year fixed-rate mortgages.

We've seen lenders charging as little as 2.99% for home equity lines of credit, making them the cheapest consumer loan around.

Once you have your loan, you only have to pay the monthly interest on what you've borrowed for the first 10 years.

After that you'll have to start repaying the principal on a regular basis as a part of your monthly payments over a 10 to 15 year period until the loan is retired.

That means your initial minimum monthly payments will be much lower and you can choose how much, or how little, of the principal to repay each month.

The drawbacks to refinancing with a HELOC.

While it may be enticing, you shouldn’t do this intending to make no more than the minimum monthly payment.

If you do you’ll be making no progress on the principal balance, and eventually you’ll be spending a fortune on interest while making no progress on the principal.

You'll need the discipline to make a significant principal payment each month to ensure that you’re working down the loan balance as if you had a fixed-rate loan.

That will give you added protection in the event that interest rates go up -- and they almost certainly will.

Home equity lines of credit are adjustable-rate loans.

The cost of most HELOCs is determined by adding or subtracting points from the prime rate -- the floating interest rate banks charge their best commercial customers. That's why you'll see rates expressed as "prime plus 1.50%" or "prime minus 0.75%."

Prime is only 3.25% right now, the lowest it's been since 1955, because the Federal Reserve has driven short-term interest rates extraordinarily low to help the economy rebound from recession.

At some point late this year or early next year, the economic recovery should be far enough along for the Fed to reverse course and allow interest rates to begin creeping up.

When that happens, the prime rate will increase, and lines of credit will become more expensive.

And it can become much more expensive than even a traditional adjustable-rate mortgage.

The initial rate on most ARMs is fixed for five or seven years and then can't go up more often than once a year. The total increase is limited to 5 or 6 percentage points above the initial rate, which works out to something like 9% to 10% at today's typical terms.

With a HELOC, rates will change as soon and as often and by as much as the Fed decides.

The prime rate increased an astounding 11 times in 2001 and the limit on how high your interest rate can go is 18% for most HELOCs.

The challenge of obtaining a HELOC

Of course none of that will matter if you can't qualify for a HELOC large enough to cover your primary mortgage.

In a traditional refinancing, your existing mortgage is automatically paid off at the closing with the proceeds of your new loan.

That isn't the case when you refinance with a HELOC.

Your home equity line of credit will be considered a second mortgage that is in addition to the existing home loan you want to pay off.

Lenders don't ask what you plan to do with a HELOC, and your existing mortgage will not be paid off at closing.

You'll have to write a check to your mortgage holder using your home equity line of credit after the HELOC is approved and funded.

As a result, most lenders will limit your total debt (the remaining balance on your first mortgage and the line of credit on your new loan) to no more than 80% of your home's current value.

So let's say your home is worth $200,000. That means you must owe less than $80,000 on your first mortgage, so that you can obtain a home equity line of credit for $80,000 and still maintain at least 20% equity in the home.

Although we've seen lenders advertise home equity lines of credit for up to $1 million, most of these loans are for $30,000 to $100,000.

For this kind of loan, that sounds about right to us.

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