Using your Heloc wisely, effectively lower your payment, but also lower your rate

Moishe Simon |

I've come across borrowers that rather keep their loan balance in a heloc (home equity line of credit) rather than a mortgage. The number 1 benefit is usually the lower monthly payments, because the heloc requires interest only payments, as opposed to the mortgage which requires principal and interest payments.  Today a standard heloc rate is prime plus .50 which is effectively 3.95%. A variable mortgage rate today is prime minus .60 which is 2.85% today. Monthly payments for 500k heloc would be about 1,646 per month, and monthly payments for a 500k variable mortgage would be around 2,064, which is 418 less per month.  From that payment of 2,064 per month approximately 1180 is interest, and the amount of interest paid per month decreases which each payment provided rates don't increase. You can clearly see why it makes sense to take the mortgage and not the heloc, however lack of cash flow can compel a borrower to take the heloc with the lower payments despite the higher interest costs. Well here is the answer for those people who need the extra cash flow but don’t want to pay the higher line of credit rates.  You go into your bank and tell them that you want to convert your line of credit into a mortgage, let’s say into a variable mortgage at 2.85. But you tell them that you are only willing to do this if they set it up as Auto Limit Increase. That means with every mortgage payment you make, the principal portion of the payment must become available to you immediately to re-borrow. In the example above, of the 2064 mortgage payment, 1180 was interest, therefore 884 was principal. Therefore 884 should be available to you right away to re-borrow at the line of credit rate of 3.95. In this scenario, after you converted your line to a mortgage, you are paying 2.85% for 499,116 and 3.95% for 884. And every month you re-borrow the principal portion again if you need the extra cash. So if you draw down every month on the principal portion you will be increasing your balance on your line of credit, but the bulk of the balance will be at the lower mortgage rate, and only the portion you re-borrowed will be at the higher line of credit rate. Before you do this you need to be very careful that the bank will make the heloc available to you, to re-borrow all the principal that you’ve repaid. Because if they don't, then you will be stuck and you won't be able to access the principal portion that you repaid. Normally they only allow this arrangement of Auto Limit Increase, if it’s a client that has an internal A credit score, or excellent internal credit rating. What you also need to factor in, is if you need to pay off the mortgage balance before maturity there will be a penalty, as opposed to keeping the balance in a line of credit which is fully open. In the case of a standard variable mortgage of prime minus .60 the penalty is 3 months interest. Therefore if your plan is to keep the mortgage balance for at least 8 months then it’s a wash, even with paying the penalty because the savings you will save from having a rate that is 1.10 lower will equal the penalty. If you keep it for more than 8 months it will be cheaper to pay the penalty, but if you keep it for less than 8 months then it will be more expensive to pay the penalty.