Should I Get a HELOC and Keep My Low Rate First Mortgage?
By Jehoshua Shapiro, Certified Mortgage Advisor, NMLS #240295
eMortgages.com | Petaluma, California
If you bought or refinanced your home when mortgage rates were significantly lower, you may now have a valuable financial asset sitting in plain sight: your existing first mortgage.
But what happens when you need access to the equity in your home?
Maybe you want to remodel your house, consolidate higher interest debt, help with college expenses, purchase another property, establish an emergency reserve, or simply have access to cash.
A common question I hear from homeowners in Petaluma, Sonoma County, and throughout California is:
Should I refinance my entire mortgage to access the equity, or should I get a HELOC and leave my low rate first mortgage alone?
For many homeowners, keeping the existing first mortgage and adding a HELOC or home equity loan deserves serious consideration.
The lowest advertised rate is not necessarily the best financial decision. The real question is what happens to the cost of all of your mortgage debt when you restructure it.
Quick Answer: Should You Keep Your Low Rate First Mortgage?
If your existing first mortgage has a substantially lower interest rate than current financing alternatives, replacing the entire first mortgage simply to obtain additional cash may be expensive.
A HELOC allows you to borrow against your available home equity while generally leaving your existing first mortgage in place.
That means you continue making your existing first mortgage payment and add a second payment based on the amount borrowed through the HELOC.
For homeowners who need only a portion of their equity, this can sometimes make considerably more financial sense than refinancing the entire first mortgage balance.
The right answer, however, depends on your loan balances, equity, current first mortgage terms, amount of cash needed, expected repayment period, and available HELOC or home equity loan terms.
What Is a HELOC?
A Home Equity Line of Credit, commonly called a HELOC, is a revolving credit line secured by your home.
The Consumer Financial Protection Bureau describes a HELOC as an open end line of credit that allows homeowners to borrow repeatedly against available home equity. During the draw period, borrowers can generally access funds up to their approved credit limit as needed.
Think of it differently from a traditional mortgage.
With a traditional mortgage, you receive the loan proceeds at closing.
With a HELOC, you receive access to a credit line and generally borrow only what you need.
If you are approved for a $200,000 HELOC but initially use only $50,000, your payment is generally based on the outstanding amount you actually borrowed rather than the entire $200,000 credit limit.
That flexibility can be one of the biggest advantages of a HELOC.
Why Would I Keep My Existing First Mortgage?
Consider a homeowner who has a large first mortgage with favorable terms.
The homeowner needs $100,000 for a remodeling project.
One option would be a cash out refinance.
But a cash out refinance does not simply finance the additional $100,000.
It replaces the entire existing first mortgage with a new mortgage.
If the homeowner owes $500,000 on the existing first mortgage and needs only $100,000 in cash, a cash out refinance could potentially replace approximately $500,000 of favorable existing mortgage debt simply to access an additional $100,000.
That is the calculation homeowners sometimes overlook.
A HELOC may instead allow the homeowner to keep the $500,000 first mortgage intact and finance only the additional amount needed.
That is why I often tell homeowners:
Do not look only at the rate on the new loan. Look at how much debt is being subjected to that rate.
HELOC vs Cash Out Refinance
A HELOC and a cash out refinance can both provide access to home equity, but structurally they are very different.
With a HELOC, your existing first mortgage generally stays in place. The HELOC becomes an additional lien against the property. You maintain your existing first mortgage payment and make a separate payment on the HELOC.
With a cash out refinance, the existing first mortgage is paid off and replaced with an entirely new first mortgage. The additional equity you are accessing is incorporated into that new loan.
This distinction becomes particularly important when the existing first mortgage has favorable terms.
A cash out refinance can still make sense in certain situations. But homeowners should understand exactly how much existing debt they are refinancing before making that decision.
What About a Fixed Rate Home Equity Loan?
A HELOC is not the only way to access equity without refinancing your first mortgage.
Another option is a Home Equity Loan, sometimes called a HELOAN or fixed second mortgage.
Instead of creating a revolving credit line, a home equity loan normally provides a lump sum at closing.
The loan is typically amortized with scheduled principal and interest payments.
This can be attractive when you know exactly how much money you need and prefer the certainty of a fixed payment.
The basic distinction is straightforward:
HELOC: Flexible credit line that allows you to borrow funds as needed.
Home Equity Loan: Lump sum of money with a scheduled repayment structure.
Cash Out Refinance: Replaces your existing first mortgage with a new, larger first mortgage.
None is automatically better. They solve different financial problems.
How Do HELOC Payments Work?
HELOCs commonly have two phases: the draw period and the repayment period.
During the draw period, you can generally borrow, repay, and borrow again up to the available credit limit.
Some HELOCs permit interest only minimum payments during this period.
After the draw period ends, additional borrowing generally stops and the outstanding balance enters repayment.
The CFPB warns that payments can increase significantly when a HELOC transitions from the draw period to the repayment period. Most HELOCs also have variable interest rates, although some programs permit portions of the balance to be converted to a fixed rate.
This is an important part of comparing HELOC programs.
A low initial payment does not tell you what the payment could eventually become.
You should understand the draw period, repayment period, index, margin, rate adjustment provisions, minimum payment calculation, annual fees, early closure provisions, and any fixed rate conversion options before selecting a HELOC.
What Is the Biggest Advantage of a HELOC?
For someone with a favorable existing first mortgage, the biggest advantage may not actually be the HELOC rate.
It may be what the HELOC does not change.
It does not necessarily require you to replace your existing first mortgage.
That allows you to separate two financing decisions:
Your existing mortgage continues financing the home under its existing terms.
The HELOC finances the new money you need today.
That distinction can be financially significant.
What Is the Biggest Risk of a HELOC?
The flexibility of a HELOC is also one of its risks.
Many HELOCs carry variable interest rates.
If the underlying index changes, the interest rate and monthly payment can change.
A homeowner who focuses only on the initial interest only payment may underestimate the future payment once the draw period ends and principal repayment begins.
There is another important consideration: your home secures the loan.
A HELOC is not the same as an unsecured credit card. Failure to repay a loan secured by your home can ultimately put the property at risk. The CFPB specifically cautions borrowers to consider their ability to make the required payments before taking a HELOC.
When Might a HELOC Make Sense?
A HELOC may deserve consideration when you have a favorable existing first mortgage, need access to only part of your available equity, want the ability to draw funds over time, expect to repay some or all of the borrowed money relatively quickly, or want an available credit line for future expenses.
It can be particularly useful for projects where expenses occur gradually.
For example, a homeowner completing a major remodel may not need the entire project budget on day one. A HELOC can allow funds to be accessed as contractors and suppliers need to be paid.
You generally pay interest based on the balance actually outstanding rather than borrowing the entire project budget immediately.
When Might a Fixed Home Equity Loan Be Better?
Suppose you know that you need exactly $150,000.
You do not expect to borrow additional funds later, and predictable payments are important to you.
In that situation, a fixed rate home equity loan may deserve serious consideration.
You give up some of the flexibility of a revolving HELOC, but you gain predictability.
For homeowners who dislike the uncertainty associated with variable interest rates, that tradeoff can be worthwhile.
When Could a Cash Out Refinance Still Make Sense?
Keeping a low rate first mortgage is not automatically the right decision.
A cash out refinance can sometimes make sense if the existing first mortgage balance is relatively small, the homeowner needs a very large amount of equity, the new financing improves some other important feature of the mortgage, or combining debts produces a materially better overall financial structure.
There may also be situations where qualifying for a second mortgage is more difficult than refinancing the first mortgage.
This is why the analysis should be based on actual numbers rather than slogans such as never refinance a low rate mortgage.
There is no universal answer.
The Calculation Most Homeowners Should Make
When comparing a HELOC with a cash out refinance, homeowners often compare:
HELOC rate versus new first mortgage rate.
That comparison is incomplete.
A better analysis considers:
Existing first mortgage balance + existing first mortgage cost + HELOC balance + HELOC cost
versus
New cash out mortgage balance + new mortgage cost
You should also compare monthly payments, closing costs, expected loan duration, principal reduction, and the amount of interest likely to be paid during the period you realistically expect to keep the financing.
This is sometimes referred to as evaluating the blended cost of borrowing.
A second mortgage can carry a higher interest rate than a first mortgage and still potentially produce a better financial result if only a relatively small portion of the homeowner’s total mortgage debt is financed at that higher rate.
That is the part of the analysis that deserves attention.
Can I Use a HELOC for Debt Consolidation?
Yes, HELOC proceeds can generally be used for many purposes, including consolidating other debts, subject to the lender’s terms.
But converting unsecured debt into debt secured by your home should be evaluated carefully.
There is a major difference between paying off a credit card and eliminating the underlying spending problem.
If credit card balances are consolidated into a HELOC and then rebuilt, the homeowner can end up with both the HELOC debt and new credit card debt.
The strategy works best when the financing decision is accompanied by a clear repayment plan.
Is HELOC Interest Tax Deductible?
Do not assume that HELOC interest is automatically tax deductible.
The IRS states that interest on a home equity loan or HELOC may generally qualify as home mortgage interest when the borrowed funds are used to buy, build, or substantially improve the home securing the loan, subject to applicable requirements and debt limitations.
Interest on HELOC proceeds used for personal expenses such as paying credit card debt generally does not qualify for the home mortgage interest deduction.
Tax circumstances vary, so homeowners should discuss deductibility with their CPA or qualified tax professional.
