There are those who make a case for using a home equity line of credit (HELOC) as a first mortgage. Although this may not always be appropriate, there are situations in which a HELOC really could be the best option for a first mortgage.
Isn't a HELOC a Second Mortgage?
The term HELOC is not interchangeable with the term "second mortgage." A "first" or "second" mortgage only refers to the loan's claim position, not its terms. HELOCs and home equity loans are often referred to as "second" mortgages because there is usually another mortgage against the property when they are taken out. Indeed, HELOCs and home equity loans generally carry higher mortgage interest rates because it's assumed that they will be in second position, and therefore riskier to the lender. If you were to default, the lender in second position would not see any money until after the lender in first position had been repaid. However, it is possible to have a HELOC in first position if there is no other mortgage on your home when you take it out.
A HELOC's Advantages
Whether as a first or second mortgage, HELOCs have their advantages:
- Low cost. It can cost less than $500 (or even nothing at all) to set up a home equity line of credit. Mortgage costs for traditional home loans can run to thousands of dollars.
- Flexibility. You can use and reuse your HELOC as many times as you like during what is called the "drawing period" -- generally the first five or 10 years of a 15- to 30-year loan.
- Easy access to funds. Traditional mortgages will not let you borrow more once you pay them off. Furthermore, if you make principal reduction payments on a traditional mortgage, you can't get that prepaid money back if you need it without taking out a new loan.
Drawbacks of a HELOC
HELOCs also come with some significant disadvantages. It's important to consider them before choosing a HELOC as either a first or second mortgage:
- Variable interest rate that's based on the prime rate. As cheap as HELOCs can be when rates are low across the board, the fact that your rate is not fixed means that your interest rate will increase when the prime rate increases, which can make budgeting more difficult. Currently, the prime rate is 3.25%, a historic low. However, the rate went as high as 21.5% in the 1980s.
- Higher interest rate based on second mortgage risk. Since HELOCs are generally second mortgages, the interest rate may be higher to compensate lenders for being in that riskier second position. Hold out for a better rate from your lender if your HELOC will be in the first position. Otherwise, you're paying the lender for assuming a risk it isn't taking. If you're counting on this borrowing capability, it's important that you also understand the current curtailments.
When a HELOC First Mortgage May Make Sense
If you're a borrower that has a small mortgage balance, or no balance at all, you might want to have access to extra emergency funds without actually having to borrow any money. Senior citizens can do this with a reverse mortgage, but if you're not a senior, or if you can qualify for a HELOC (which costs much, much less than a reverse mortgage), setting one up could be a very financially-sound decision. If retirement is near and you have concerns about qualifying for a loan once your income has dropped, setting up a HELOC now could provide a very valuable safety net for a very low cost. If you don't need a lump sum all at once -- for example, if you're paying annual college tuition for your child -- a HELOC lets you only pay interest on the amounts you actually use.
When to Avoid a HELOC First Mortgage
Some mortgage "advisers" have advocated replacing a low-balance mortgage with a HELOC to maximize a home loan interest deduction, because as the loan approaches retirement, most of what you pay each month goes toward the principal, unlike the beginning of a mortgage term when the lion's share goes to interest. The logic goes like this: Re-start your loan's amortization all over again and pay less toward principal so you can get a bigger mortgage interest deduction.
However, those who advocate this are missing two points: First, by starting the clock over again, you may substantially increase the amount of interest paid over the life of the loan, and second, your home interest deduction is pennies on the dollar. So, paying more interest to get a bigger deduction only makes sense if you shift interest expenses from non-tax-deductible sources, like credit cards, to deductible sources, like your home's mortgage interest. Otherwise, it simply makes no sense.
HELOC Alternatives to Consider
Before you replace a first mortgage with a HELOC, consider a no-cost refinance. A no-cost refinance comes with a higher mortgage interest rate than a traditional home loan with points, costs and fees, but it might be lower than the interest rate on a HELOC. A fixed rate makes your loan more predictable and budgeting for payments easier.
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