Disclaimer: Wesley Mortgage does not currently offer HELOCs. We are providing this information to keep you informed.

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Often, a homeowner will want to refinance their primary, or first mortgage. If a homeowner refinances, they can usually get a new mortgage loan with better terms that the one being refinanced. However, many run into a problem: their home equity line of credit (HELOC). Can someone refinance their primary mortgage if a HELOC is connected to it?

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Furthermore, can someone use a cash-out refinance to pay off their HELOC debt? This article will help unravel these questions.

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HELOC vs. Home Equity Loan

There are primarily two ways to borrow against the equity in your home: a home equity loan and a home equity line of credit (HELOC). Both use your home equity as collateral to finance the loan. However, each loan works differently.

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HELOC Overview

In a HELOC, one receives a credit line associated with how much they can afford and how much equity they currently have in their home. This spending limit is the maximum amount of money one can borrow using this line of credit. However, the borrower doesn't have to use all the credit at once. Instead, the HELOC simply opens a line of credit to the borrower. A HELOC functions like a traditional credit card. The only difference is that this line of credit is secured by your property and your equity in the property.

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A HELOC also functions in two major stages: a draw period and a repayment period. During the draw phase, a borrower can withdraw funds up to the limit of that line of credit. It's not uncommon to have this phase last ten years.

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After the draw period, a borrower enters the repayment period. In this period, the borrower can no longer withdraw funds from this line of credit. Instead, they must begin paying back the balance on the HELOC at the time the draw period ended. Now the HELOC functions similar to a traditional mortgage loan.

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HELOCs typically are adjustable rate loans, but may be fixed rate as well. Payments due during the draw phase are usually a percentage of the balance outstanding and interest is assessed monthly on the balance outstanding. 

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Home Equity Loan Overview

A traditional home equity loan operates as a second mortgage, but may also be a first mortgage. In this loan, the borrower is given a lump sum of money at closing that must be repaid over a predetermined loan term.

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Payments on this loan type are similar to traditional mortgage loans and personal loans. Monthly payments are comprised of interest due and a portion to be applied to reduce the loan’s principal balance. The interest rate on a home equity loan will depend on the rates one secures when they first receive the loan, but may be adjustable rate or fixed rate.

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Refinancing with a HELOC

Many people wonder how to repay their HELOC once it enters its repayment period. When a HELOC is in its repayment phase, homeowners still have to make monthly payments on their first mortgage plus the monthly payment on the HELOC. 

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In these situations, homeowners look for quick ways to repay their HELOC debt. A quick repayment method many homeowners have found to be effective is using a cash-out refinance to pay off their HELOC.

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What is a Cash-Out Refinance?

A cash-out refinance is the process of replacing your current mortgage with a larger mortgage loan. This method works if your home has gone up in value since your original mortgage or if you have paid down your first mortgage, thereby building equity in the home. However, there needs to be a significant difference between the new market value for the home and the current balances on the first mortgage and HELOC to make a cash-out refinance worthwhile. Keep in mind that  a cash-out refinance has high closing costs. Still, it can be a quick way to gain additional income.

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Can You Use Cash-Out Refinance to Pay-off a HELOC?

Yes, you can. It's a practice many homeowners utilize each year. Often, homeowners are worried their interest rates might increase on their HELOC once the loan transitions into its repayment period if it is an adjustable rate loan. So homeowners have been known to use a cash-out refinance to repay their HELOC in full. Lenders don't limit cash-out refinances to specific purchases, making this methodology a legitimate way to pay off a HELOC.

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What is Loan Subordination?

Getting multiple loans on a property can become tricky due to loan subordination. Loan subordination is the process of determining the hierarchy of loans for a given property.  For example, a first mortgage loan originated in May of 2015 will always remain the first lien position.  A subsequent second mortgage, including a HELOC, will then be in a second lien, or junior lien position. 

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Lien position is determined by mortgage recording date. If the first mortgage is refinanced, the junior lien will now be in first lien position because the refinanced first mortgage will have a later mortgage recording date.

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This is when a subordination agreement takes place.  The junior lien holder agrees to remain in second lien position and the refinanced first mortgage can be in first lien position.

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Many lenders have subordination departments specializing in sorting subordination requests on their properties. One way to resolve a HELOC/mortgage refinancing subordination issue is to group your primary mortgage loan into your HELOC with a refinance of both.  Or a subordination agreement can be presented to the HELOC lender asking that they agree to remain in second lien position.  Depending on the HELOC lender, they may or may not approve this request.

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Downsides of a HELOC

HELOCs are a valuable source of income. However, you still have to pay back the loan during its repayment period. It can seem like free money, but it's not. Every dollar you spend on your HELOC, you'll have to repay with interest.

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Furthermore, you stand to lose your home if you default on your HELOC. This consequence is a serious reminder of how HELOCs work. They are secured by your home and  the equity in your home. Don't use these lines of credit if you are not able to repay the loan.

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Another major downside of a HELOC is the possibility of the real estate market tanking and the lender restricting your approved credit line. HELOCs are long-term lines of credit that can last years. For instance, the traditional draw period on a HELOC is ten years. A lot can shift in the housing market during the life of a HELOC - for good or ill. The value of your home can shrink during the life of your HELOC. In this situation, you still owe the lender the balance outstanding at the time the draw period ends.

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What You Should Know Before Refinancing Your First or Second Mortgage

You need to understand several dynamics if you plan to use a cash-out refinance to pay off your second mortgage or HELOC.

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Penalties for Prepaying Your Home Equity Mortgage

Before you use your cash-out refinance to pay off your second mortgage, be aware that some mortgages have penalties for prepaying your loan balance. Not all mortgages have these. Still, it's a dynamic worth considering.  Check your loan documents or consult with your lender or servicer to determine if you have a prepayment penalty that would be assessed if you pay off your second mortgage.

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Penalties on HELOCs

HELOCs also have potential fees for paying off these loans early. Generally, these fees lessen as time goes by. So consider these prepayment fees if you've taken out your HELOC recently and review your loan documents or consult your lender to determine any applicable prepayment penalties.

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Concluding Thoughts

In summary, it is possible to keep your HELOC if you choose to refinance, as long as the HELOC lender agrees to subordinate. Furthermore, it's also possible to use a cash-out refinance to pay off one's second mortgage or HELOC debt. 

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