The traditional home equity line of credit, or HELOC, is a line of credit tied to your home, and most people with HELOCs also have a primary mortgage. But there’s another type of HELOC — the first-lien HELOC — which is also referred to as an “open-end mortgage,” “all-in-one mortgage” or “first-position HELOC.” And you can use it to buy or refinance a home.
What Is a First-Lien HELOC?
Like most traditional HELOCs, a first-lien HELOC is a line of credit secured by your home, and it comes with a variable interest rate. It usually has a draw period, when you can tap the line to cash in some equity, and a repayment period, when you can’t tap the line anymore and you pay it off in installments.
But there are significant differences that can make or break your decision to finance a home with a first-lien HELOC.
[READ Best HELOC Lenders]
How a First-Lien HELOC Is Different
A first-lien HELOC is not just a loan that you write a check to pay each month. It’s more like a combination checking account, credit line and mortgage. With a first-lien HELOC, you only have one loan and one debt source that’s tied to your home.
First-Lien HELOC Setup
You link a new checking account and your earnings to the first-lien HELOC. That means your paycheck and other deposits are automatically swept into your HELOC and applied toward your principal owed, thereby lowering your loan balance. Any of your earnings that you don’t spend that month stay in the account.
Interest Rate and Payment
A first-lien HELOC applies an adjustable interest rate to the previous month’s average daily principal balance. You’re required to make a minimum, interest-only payment during your loan’s draw period, and any extra funds in the account go toward reducing your principal. Every dollar that you earn and don’t spend goes toward accelerating your mortgage payoff.
Draw and Repayment Period
During the loan’s draw period, you can tap your credit line. When the draw period ends, you must make fully amortized principal and interest payments over the remaining loan term. Some “all-in-one mortgage” HELOCs have an unlimited draw period, permitting you to regularly tap your home’s equity across the loan’s entire term (which can span up to 30 years). Note that if you don’t pay off your loan within its term, you’ll face a balloon payment. You must be prepared to refinance that balance or pay it off.
Pros of First-Lien HELOCs
Thanks to its being tied to your checking account funds and deposited paychecks, a first-lien HELOC can help you save thousands otherwise spent on interest payments and help pay off your mortgage debt sooner. That’s because HELOC interest is based on your average daily balance for the previous month, not your balance at the end of the month. When your payroll and other deposits hit your HELOC account, the average balance is reduced.
Depending on your spending habits, you can use this feature to pay less interest than you might with a standard fixed-rate mortgage. Every unspent dollar in your account goes toward accelerating your mortgage repayment. But if you need to tap your credit line, you can.
You’re allowed to draw money at any time over the predetermined draw period — often three to 10 years with some first-lien HELOCs or anytime with an all-in-one mortgage. You borrow only what you need, when you need it. Interest accumulates monthly, but you are only obligated to pay off the interest that has accrued for that particular month.
This access to cash can be a real advantage — you can fearlessly prepay as much of your loan as you want, knowing that you can pull the money back out if the need arises. For instance, instead of keeping your emergency fund in a separate savings account, you keep it in your HELOC account. This helps you reduce your loan balance and incur less interest. And as long as you spend less than you deposit, your loan payoff is accelerated.
“This method is a great way to pay your home off early, so long as you consistently contribute more toward the principal balance of the loan than you draw on for expenses,” says Evan Luchaco, home loan specialist for Churchill Mortgage in Portland, Oregon. “I’ve seen diligent homeowners pay their home off significantly earlier than a standard 30-year term mortgage — some as quickly as seven to 10 years.”
Lenders view a first-lien HELOC as less risky because it serves as the main loan on your home. If you can’t repay and your property gets sold, the lender is the first to recoup its money, with no other loans standing in its way. This lower risk usually translates to more attractive interest rates than a traditional second-lien HELOC.
A first-lien HELOC takes over as your only home loan, combining everything into one simple payment. You’re also at a much lower risk of missing any payments because your income and funds are merged with your HELOC.
Finally, a first-lien HELOC can be part of a larger financial strategy. Even after paying it off, you can tap it any time during its draw phase for other uses, including investments.
“Let’s say you have the (first-lien HELOC),” says Reed Letson, mortgage broker and owner of Elevation Mortgage in Colorado Springs, Colorado. “And you are gainfully employed, getting raises every year, etc. The mortgage is paid off in six years. Now you have access to that money. … (This) would also be ideal paying off 25% high-interest credit cards, lowering your total interest charge on your debt. Or if an investment opportunity arises, where you would normally not have the spare cash if it is locked away in your 30-year (fixed-rate mortgage).”
[SEE: Best Home Equity Loans]
Cons of First-Lien HELOCs
On the downside, the interest rates are variable and are usually higher than fixed-rate mortgages. HELOC rates are tied to the prime rate, which is the interest rate that banks charge their most creditworthy customers. As of April 24, the prime rate is 7.5%.
“I’ve seen first-lien HELOC rates around 1% to 2% higher than for traditional mortgages, but way better than credit cards or personal loans. The lender is taking less risk being in first position, which explains the decent rates,” says Andrew Lokenauth, founder and publisher of The Finance Newsletter. “However, the variable rates can make budgeting tricky. And you’ve got to be disciplined — it’s way too easy to tap into your equity for unnecessary stuff.”
Consider, too, that in an environment where rates are stable or decreasing, you can anticipate stable or improving monthly interest-only payments. “But in an environment where rates are rising, what you originally anticipated as a reasonable payment can turn into a financial hardship,” says Luchaco. “I’ve seen homeowners who get behind on their monthly HELOC contributions, causing a negative snowball effect where the monthly interest accrues more and more debt every month. As there is more debt, the monthly interest-only payment also increases.”
HELOC payments can increase sharply after the draw period ends and the repayment phase begins. Instead of interest-only minimum payments, your remaining payments must be fully amortizing and clear the balance by the end of your loan term. For loans with no repayment phase, you may have to make a balloon payment or refinance your balance at the end of the loan term.
There are a lot of moving parts with these loans. Borrowers with less financial experience could find themselves in trouble if they spend more than they earn or if they can’t afford the payment when their draw period ends.
Qualifying for a first-lien HELOC can be more difficult. To be eligible, you’ll need:
— A credit score typically 680 or higher
— A debt-to-income ratio of 43% or lower
— Proof of sufficient, consistent income
— Significant equity in your home — typically 20% minimum
[READ: Compare Current Mortgage Rates]
Good Candidates for a First-Lien HELOC
This financing option works well for the right borrowers.
“The ideal candidate has stable income, strong cash flow management skills and no high-interest debt. They’re looking to accelerate mortgage payoff through strategic use of their regular income and savings — not looking for additional borrowing capacity,” says Lokenauth.
“This fits homeowners with solid equity. If your mortgage is paid off or nearly there, it’s a great way to access cash without a rigid loan,” says Steven Glick, director of mortgage sales for HomeAbroad. “It’s best for people who won’t treat it like a personal ATM. I’ve also seen it work for business owners needing quick funds or retirees wanting a cushion without monthly mortgage pressure.”
Self-employed individuals with healthy earnings are worthy prospects, too, says Letson. “This is also ideal for people who have a hard time saving money, as this loan acts as a forced savings account that you can draw from whenever you need extra cash. People who do not want to be stuck in a traditional 30-year mortgage without sacrificing the payment flexibility you would lose by having a shorter-term mortgage can also benefit.”
However, if you have a mortgage with a low fixed interest rate, it’s probably not worth replacing that loan with a first-lien HELOC for which the variable rates will almost certainly be higher.
“I’ve found the HELOC rate needs to stay within about 1 to 1.5% of the fixed rate for the math to work out,” Lokenauth says.
First-lien HELOCs are probably not for those who don’t plan to accelerate their mortgage repayment, says Glick.
“If you’re tapping the HELOC to spend more than you deposit, it’s a lousy deal. You’re just stacking 8% debt with your house at risk. The only win then is maybe money saved on closing costs versus a second loan, which isn’t much unless rates plummet. This is for folks who’ll deposit more than they pull. Otherwise, it’s a bust.
“But if you are sitting at a fixed rate of 6% or more, a first-lien HELOC might be worth it,” Glick says. “Run the numbers and make sure the savings on interest outweigh the costs, like closing fees.”
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You Can Buy or Refi With a First-Lien HELOC — But Should You? originally appeared on usnews.com
