You may be familiar with a home equity line of credit, or HELOC, as a way to use the equity in your house as cash as needed. People use HELOCs for all kinds of things, such as home improvements, consolidating debt, or paying for education.
Traditionally, people think of a HELOC as a second loan on their homes, which sits “behind” their first mortgage. Actually, a first lien HELOC is another option to replace your mortgage and also have access to your equity in the same way that a second lien HELOC does.
Curious? Let’s explore how a first lien HELOC works and some of the ways you can use this type of loan to your advantage.
What Is a First Lien HELOC?
Every time you take out a loan on your house, the loan has a “position” or place in line. A typical 30-year fixed-rate mortgage usually sits in “first” position. This is the loan that most people get when they buy or refinance their homes.
A traditional HELOC usually sits in “second” position. First mortgages include a principal and interest payment over the term of the loan. A HELOC is more like a credit card, where you can withdraw money as needed, paying interest on the amount withdrawn.
Let’s say you buy your house for $200,000, and your mortgage is for $150,000. A few years later, you want access to the equity in your home, so you take out a HELOC for $20,000. The loan for $150,000 would be your first mortgage, and the HELOC would be your second mortgage.
However, if you have a first mortgage, it is also possible to refinance your first mortgage into a first lien HELOC. This all in one HELOC still gives you the benefit of access to your equity with a single loan.
Advantages of a First Lien HELOC
When you replace your mortgage with a first lien HELOC, you’ll have more flexibility and save money. There are several advantages of opting for a first lien HELOC over a traditional first lien mortgage and second lien HELOC combo:
Lower Closing Costs
Between lender fees and title fees, mortgages typically cost thousands to close. HELOCs have very few fees. Most banks will also cover your title expenses and appraisal fees so that the amounts are not added to the amount borrowed.
One way to gain access to the equity in your home is a cash-out refinance. This is where you increase your loan amount and take out the excess as a lump sum.
The problem with this type of loan is that you will pay all of the costs to refinance. Then you will accrue a lot of interest as that cash amount is wrapped into the term of your loan.
With a HELOC, you can use your equity over and over throughout the draw period of the loan. Let’s say you draw on your HELOC for some home improvement expenses and then pay it back. You then have access to the full amount of equity again and can draw a second time to pay off some higher interest debts.
With a traditional mortgage, if you wanted to access your equity a second time, you would need to do another cash-out refinance. You would need to pay the closing costs all over again.
Easy Access to Your Equity
Your expenses with a HELOC do not have to be large. If something comes up that you need to pay, you can quickly access your HELOC money as emergency funds. This gives you a valuable safety net for a low cost.
With a traditional mortgage, you can’t access the equity automatically as you pay down the loan. If your loan starts out at $150,000 and after a few years you have paid it down by $20,000, you don’t have access to that $20,000 in equity. You would need to take out a new loan to get the cash.
HELOCs can also be tied directly to checking accounts. This simplified banking approach makes your access to the HELOC funds seamless and also can cover overdraft protection.
How a First Lien HELOC Works
By now, you’re probably intrigued about a first lien HELOC and wondering how you can get one. Whether you have only a traditional first mortgage now, or a first mortgage plus a HELOC, you can take a look at the steps to apply for a first lien HELOC.
Replacing Your Mortgage
When you access your equity through a traditional cash-out refinance, your existing mortgage is replaced with a new one. Your existing loan would be paid off through the refinance process, and you would start over with a new loan and new loan amount, receiving the cash funds at closing.
With a first lien HELOC, the process to replace your mortgage is similar. The existing loan is paid off and replaced with your first lien HELOC. The difference is that as you pay down your first lien HELOC, that equity becomes available for you to access.
Your existing mortgage would have been in first lien position. When it is paid off, your new HELOC takes its place as first lien.
Save Money On Interest
The way interest is calculated on a HELOC is much different than a traditional mortgage. Interest calculations make a huge difference in how much interest you will end up paying. You can end up saving a lot of money with HELOCs versus mortgages.
A mortgage will take the principal balance of the previous month, and that is the amount used to calculate interest. Because of this, if you make a principal payment in the current month, it doesn’t change how much interest you owe that month.
A HELOC calculates interest from the average daily balance. This means that your interest is calculated daily, using that day’s principal balance. When you decrease your principal throughout the month, your interest payment also decreases.
With a HELOC, every payment you make immediately reduces your principal and the amount of interest you owe. This can result in huge cost savings.
You can save in other types of interest as well. If you use your HELOC for debt consolidation, you can pay off higher interest debts, such as credit cards. With access to the emergency use of a HELOC for unexpected expenses, you will not need to turn to credit cards in the future, which will also save you interest.
HELOCs can also have tax benefits as deductible interest. Contact a tax professional to find out more.
Easily Manage Your HELOC Payments
You’ll have a lot more control over paying down your mortgage with a first lien HELOC. Many borrowers are able to pay off their loans early by using a “cash in, cash out” method with a first lien HELOC. Here’s how it works.
First, you’ll deposit 100% of your income to the first lien HELOC. Because interest is calculated daily, you’ll immediately be reducing your principal balance and the interest calculated.
Next, you’ll pay all of your monthly expenses from the HELOC. The difference between your monthly income and your monthly expenses becomes the amount that pays down the principal on your HELOC.
Have a month where you have less money than you expected due to higher expenses? No problem, since HELOCS the minimum on a HELOC is an interest-only payment. This is different than mortgages that have a fixed principal and interest payment every month.
Applying for a First Lien HELOC
You may wonder what you need to qualify for a first lien HELOC. Like any mortgage, income and credit scores will be a huge factor. But generally, if you qualify for a mortgage, you will qualify for a HELOC.
Many first lien mortgages are backed by government agencies (like Fannie Mae or Freddie Mac). But for HELOCs, banks set their own standards for qualification.
You can ask your lender about the interest rate and margin for a HELOC, and also if there is an introductory rate. Chances are, the lower your credit score, the better the interest rate you will receive.
Changing Your Financial Strategy with a First Lien HELOC
For decades, banks have relied on traditional mortgages to make money. Fixed interest rates and terms are steady income from borrowers. High closing costs are an incentive for banks to want borrowers to refinance over and over to access their money.
But times have changed, and borrowers are savvier. They want to explore alternatives that give them more control over their home loans. A first lien HELOC gives them the option to pay down their loans faster while still accessing funds when needed.