Making plans to pay off your mortgage is a fantastic way to improve cash flow and get out of debt. Becoming debt free would allow you many freedoms which are so rare in the world today.
While paying off debt is not rocket science, there are some debt payoff methods which can help speed up getting out of debt.
One debt payoff method homeowners think they can use to pay off their mortgage fast is by utilizing a HELOC (home equity line of credit).
If your HELOC rate is lower than your mortgage rate, it is possible to reduce your interest expense and perform interest rate arbitrage.
But, in general, does using a HELOC allow you to become mortgage free faster?
In this post, let’s explore using a HELOC to pay off debt fast, when using short term debt can help cancel long term debt, and how performing mortgage and HELOC arbitrage works.
What is a HELOC?
A HELOC (pronounced HE-lock) is a home equity line of credit. A HELOC is a loan, which using your home as collateral, and lets you borrow up to a certain amount, rather than a set dollar amount.
HELOCs are similar to credit cards. They have a credit limit, and you can borrow against it, pay all or part of the balance, and borrow again up to the credit limit.
The interest rate typically is variable and depends on the Prime rate.
How does a HELOC work?
HELOCs have terms which have many varieties and can be customized depending on your preferences.
Typically, the first 5 or 10 years of a HELOC will be established as the draw period. During the draw period, you may borrow from the HELOC and the minimum monthly payments are interest only.
After the draw period expires, the repayment period begins. Usually, the repayment period will be 20 years.
During the repayment period, you will be paying both principal and interest. After the 20 years, your entire HELOC will be repaid.
Also, similar to a mortgage, missing a payment could have a negative effect on your credit score or result in a foreclosure.
We’ve established what a HELOC is and how a HELOC works, let’s examine paying off your mortgage with a HELOC. First, let’s define arbitrage.
What is Arbitrage?
Before getting into the numbers, let’s talk about a money making theory. What is arbitrage? As defined by Investopedia,
Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price.
Arbitrage is performed when you can extract risk-free profit from a difference in the pricing of your investments.
One common example is when you borrow money at 3%, and invest the money at 4%. The difference between your borrowing cost and investment yield is 1% – you are banking 1% for free!
Many professional money managers look to make money risk-free with arbitrage. However, the average person can use arbitrage to their advantage as well!
If you can find these arbitrage situations, you should try to capitalize on them!
A Real Life HELOC Example
After applying for a HELOC, you will receive an offer. Depending on your lender, the credit line will be dependent on the current equity in your house.
When I went to apply for my HELOC, I received the following quote: a $21,000 credit line with a 7.6% variable interest rate. For my HELOC, there would be a 10 year draw period and 20 year amortization period.
This interest rate is not amazingly low, but could lead to some interest rate arbitrage.
One thing to note is HELOC interest is not tax deductible for all expenses. HELOC interest is tax deductible as long as it is used to make improvements to the home, but isn’t deductible if the money is spent on anything else.
An Example of Paying off Your Mortgage with HELOC Funds
When I got my HELOC, I wanted to look and see if I could strategically pay off my mortgage to better my situation financially.
Let’s examine an example where I would take HELOC funds and look to reduce my mortgage balance to get rid of private mortgage insurance.
My mortgage is a 5/1 ARM mortgage with a 2.625% interest rate. At this time, I’m not quite at 20% equity and still have private mortgage insurance. There are 3.75 years until my interest rate adjusts.
Over the next 10 months, I theoretically could pay an extra $25,290 and get rid of the $144 a month private mortgage insurance (PMI).
This would result in a 8.43% return on investment. This is a guaranteed 8.43% on my cash over 3.75 years since the debt will be paid off.
While this mortgage payoff scenario sounds great, what if I could arbitrage this return by using debt at 7.6% and keep my cash? Would using a HELOC to pay off my mortgage be worth it?
Examining a Potential Mortgage and HELOC Arbitrage Opportunity
To get rid of PMI, I’m about $25,000 of principal away. Thinking about using my HELOC to finance this debt reduction, I would still need to put up some cash. However, If I used all of the $21,000 credit line to pay off my PMI, I would free up $144 of cash flow a month, and accelerate my mortgage amortization.
After this payment, I would have interest-only payments on the HELOC of 7.6% on $21,000 for $133.
Looking at this, I’d be saving $11 a month without doing anything, and I’d speed up my mortgage amortization (pay off my mortgage faster). If I kept paying the minimum on my mortgage (2.625%), it would take 29 more months to get rid of PMI.
Therefore, I calculated the rate of return at the 29 month mark to find the profit potential:
Over 29 months, I’d make $1,651 on my $21,000. This equates to an annualized return of 3.25% created for free from this potential arbitrage opportunity.
The $1,651 return on investment from this HELOC debt payoff strategy could even be added as extra mortgage payments to help pay off my mortgage debt even faster.
At the same time, it can be pretty risky to use debt to pay off other debts.
Also, if I was just using the HELOC to pay off mortgage principal, I would lose over $2,500 over the 29 months due to the difference in interest rates. The example above only works since I’m still paying off private mortgage insurance.
Finally, the HELOC interest rate is variable with respect to Prime, and as a result could increase. If interest rates go up, what I’ve calculated above could certainly be unprofitable.
Everyone’s situation is different. For you, if you are thinking of paying off your mortgage with HELOC funds, it’s important to calculate your potential gains or losses ahead of any actions.
How Else Can You Use HELOC Funds?
While paying down your mortgage with a HELOC might seem like a good idea, there are potentially more optimal ways you could use your HELOC funds.
Other potential options for the HELOC funds could include:
- funding a brokerage account
- using your credit line as insurance in case of a major emergency
- funding a down payment for a rental property
- funding a retirement account (401k, 403b, 457 plan, Traditional or Roth IRA)
Putting your money to work in the stock or real estate market might make sense for you if interest rates are low.
With stock and real estate investments, there is no guarantee of profits. However, in the long run, the stock market return 7-10% a year on average, and real estate investments return 10-20% a year on average.
If you are not risk adverse and are looking to use arbitrage and leverage to your potential advantage, a HELOC can be a low cost way to finance your investments.
If you are risk adverse and hate debt, just having a HELOC in case of emergency could help you sleep peacefully at night. Also, with another line of credit open, you could increase your credit score.
There are so many options for using HELOC funds and ultimately, the decision is yours. Personal finance is personal!
Paying Down Your Mortgage with a HELOC could be Smart or Dumb
Getting out of debt and becoming debt free is a goal which everyone should have. Becoming financially free from the bank will allow you to live the life you want and deserve.
Depending on your mortgage interest rate and your HELOC interest rate, using your HELOC funds to pay off your mortgage could be a good idea, or a bad idea.
Since HELOC interest is not fully tax deductible anymore, there is less incentive to use HELOC for arbitrage. It is still possible to find interest rate arbitrage opportunities, but just more difficult.
If your HELOC interest rate is lower than your mortgage rate, you can make money. If your HELOC interest rate is higher than your mortgage rate, then you will lose money.
For you, thinking critically about your personal finance situation will lead you to the right answer.