Paying off your mortgage with a home equity loan

For quite a while, Jerry and Staci Reichelscheimer wanted to refinance their mortgage to get a lower rate. But they balked at the closing costs. Then they had an idea -- why not pay off their mortgage with a no-cost home equity loan?

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So they did. They got a home equity loan with no closing costs and used the proceeds to pay off their primary mortgage, effectively turning their equity loan into a first mortgage.

What the Reichelscheimers did might not work for you, but it demonstrates the value of thinking creatively about how to manage your debts.

Using a home equity loan to pay off a primary mortgage is a recent phenomenon that "has come on my radar screen lately," says Bob Walters, senior vice president of secondary marketing for Quicken Loans. Such a transaction makes sense for two kinds of borrowers, he says. The biggest group comprises people who don't owe much on their mortgages. The other group consists of affluent and financially savvy homeowners who can afford to take some risks.

Retire a small mortgage
Of the first group -- people with small mortgage balances -- Walters brings up a hypothetical case of someone who owes $23,000 and is paying at a rate of 8 percent. It would be hard to find a lender that would bother with refinancing such a small amount, and then the fees could easily exceed 10 percent of the loan amount.

The way around the low-balance roadblock is to get a no-fee equity loan or line of credit to pay off the first mortgage while getting a lower rate. Walters calls this the "cleanup mortgage."

Then there's the cross between a cash-out refinance and an equity loan. Tom Drennan, executive vice president for mortgages at Astoria Federal Savings in Lake Success, N.Y., says a recent customer owed $7,000 on a mortgage and got a $25,000 equity line of credit. After paying off the first mortgage, the borrower has $18,000 remaining on the line of credit. Fees were minimal.

Manage a big mortgage
At the other end of the spectrum are homeowners with big balances and expensive houses. These homeowners can pay off their primary mortgages with home equity lines of credit, or HELOCs. The advantage of a HELOC is a low rate. The disadvantage is that the rate is variable, and as this article is written in February 2003, HELOC rates have nowhere to go but up.

"Taking out a HELOC at these terrific rates, they are saving tons on their mortgage," Walters says. But these borrowers have to be able to "take on the economic changes" when rates rise.

A HELOC usually requires you to pay only the interest on the outstanding balance, so you have to exercise self-discipline to pay principal. And the entire amount can come due when you sell the house or at the end of a specified repayment period, often 15 years.

The Reichelscheimers fit into the big-balance category. Instead of getting a HELOC, they got a fixed-rate home equity loan. They're confident that they made the right choice, considering all the circumstances.

They have owned their two-story Victorian in Melville, N.Y., since 1998, when they got a 30-year mortgage at 7 percent. In the summer of 2002, the house was worth about $500,000 to $550,000 and they owed $241,000 on the mortgage. They searched around for refinancing deals, but were turned off by the fees, which would be at least $3,000 -- plus New York's mortgage-recording tax of 0.75 percent of the loan amount, which would amount to another $1,800.

Then they saw an advertisement for FleetBoston Financial's 20-year home equity loan, which is marketed as a way to refinance and consolidate debt without paying points or closing costs. In July 2002 they traded their 30-year, 7 percent loan for a 20-year loan at 6.25 percent. Two months later, they restructured the home equity loan to get a rate of 5.99 percent. Their monthly payments are almost the same, but they cut years off the repayment period.

"Could we have gotten a 20-year at 5.5 (percent)? It's a possibility," Jerry Reichelscheimer says. But the lower rate would have come at the expense of thousands of dollars in fees.

Before homeowners take out equity loans to pay off their mortgages, they should take a look at no-closing-cost refinancings, says Brian Peart, president of Nexus Financial, a mortgage lender. With these loans, the lender pays the closing costs and charges a slightly higher interest rate. Under some circumstances, this can result in lower monthly payments than rolling the closing costs into the loan at a slightly lower rate.