HELOC Balloon Payments: How to Find a Way Out
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Over 1.4 million home equity lines of credit (HELOCs) taken out just before the housing bubble burst was on track to enter repayment in the years 2017 and 2018, according to a 2015 report by RealtyTrac (now ATTOM Data Solutions).
This could serve as a shock to a number of homeowners, because monthly payments were expected to increase by an average of $145-$161, and some of these HELOCs require balloon payments at the end of their repayment period that could be difficult to either pay or refinance.
In fact, RealtyTrac estimated that 770,000 of those HELOCs entering repayment in 2017 and 2018 are seriously underwater, meaning that the total outstanding debt on the home is 125% or more of the home’s value, making a refinance a difficult proposition.
All of which is to say that if you do have a HELOC with a balloon payment on the horizon, now is a good time to start thinking about how to get out.
- How HELOCs work
- Avoiding HELOC balloon payments
- How to qualify for a HELOC refinance
- Other ways to retire your HELOC
- Getting out of your HELOC balloon payment the smart way
How HELOCs work
If you have positive home equity — meaning your home is worth more than the outstanding balance on your mortgage — a home equity line of credit (HELOC) can be a helpful way to tap into that equity for other financial needs.
A HELOC opens up a line of credit against your equity that you can access somewhat like how you use credit on a credit card. You have a maximum amount you can borrow, you’re allowed to borrow money as you need it and you’re only charged interest on the amount you borrow.
HELOCs typically have two stages:
- A draw period, during which you can borrow money and make interest-only payments.
- A repayment period, during which you can no longer borrow and you have to start making payments that include both principal and interest. HELOCs have adjustable interest rates, so your payment can increase or decrease over time.
Some HELOCs also require a balloon payment at the end of the repayment period. A balloon payment is generally at least two times the amount of a normal monthly payment but can be tens of thousands of dollars. These payments are required when the monthly payment isn’t large enough to completely pay off the loan during the repayment period.
Balloon payments are risky for two main reasons.
First, you may not have the cash to make the payment when it’s due. Even if you save for it ahead of time, you never know what life will throw your way and what you’ll have to use the money for before that balloon payment comes due.
Second, while it is possible to refinance your HELOC before the balloon payment comes due, there’s no guarantee you’ll be able to do so or will receive favorable loan terms. If your home has decreased in value, you may not have enough home equity for a refinance. And if your credit has taken a hit, you may not be eligible for a new loan or may have to pay more in order to get it.
Avoiding HELOC balloon payments
If you have a HELOC balloon payment on the horizon and you’re unsure how you’ll pay it, or if you want to remove the uncertainty that comes with an adjustable interest rate, you have a few options.
“Typically, I would have a client refinance to see if they can get a fixed rate,” said Brian Face, a fee-only financial planner and the founder of Face 2 Face Financial Planning. “A HELOC is not meant as a long-term situation, especially if it has a balloon, and refinancing allows you to get a better rate that’s fixed.”
Refinancing both your first mortgage and your HELOC into a single new mortgage can potentially accomplish a few goals.
First, it can lower the lower interest rate on both loans, which can save you money both in the short term and the long term.
Second, it can lower your monthly payment. This can ease the strain on your monthly budget and ensure that you’re able to sustain paying off this debt while also meeting your other financial obligations.
Third, it can turn the adjustable interest rate on your HELOC into a fixed interest rate.
“If we know that interest rates are going up, which is the only way they can go right now, you might not be able to afford the increasing payments,” Face said. “Rates are still near all-time lows, and by refinancing, you can lock that rate in.”
Fourth, it can remove the balloon payment and effectively spread out that payment over a longer period of time. This not only removes the need to come up with that big, one-time payment, but it can also remove the stress that comes from anticipating that future payment.
“If it goes to the balloon, you’re going to have a giant payment that’s due,” said Face. “If you don’t have the money you’ll eventually have to make some kind of decision, so you might as well make it now.”
Breaking the debt cycle
One of the biggest benefits of refinancing your HELOC is that it can help you break out of the cycle of debt.
A HELOC allows you to borrow as needed during the draw period, which can reinforce the habit of using debt to pay for financial needs. The interest rate and monthly payments can then increase during the repayment period, which can make the HELOC difficult to afford and may push you further into debt.
Finally, the balloon payment often has to be refinanced if you can’t pay for it with cash, which further prolongs the cycle of debt and may force you into a more expensive loan than you’d like.
By refinancing now and locking in a fixed payment, you can stabilize your financial situation and break out of that debt cycle.
In the immediate term, you remove the uncertainty around your fluctuating monthly payment and the future balloon payment. You can create a budget around one stable payment, reducing the odds that you’ll have to resort to other types of debt just to afford your bills.
In the long term, once you have paid off your refinanced loan, you can put that fixed monthly payment toward other goals such as paying off other debt or building up savings and investments that will lead to a better, more secure financial future.
Downsides to refinancing your HELOC
The biggest downside to refinancing your HELOC is that you will have to pay closing costs that add to the cost of your debt. Whether those costs are worth it largely depends on how long you plan on staying in the house.
“If you’re only planning on staying there for one more year, it might not make sense to spend the money on a refinance,” Face explained. “If you think you’re going to stay there for a few years, I would tell people to get out of their HELOC.”
Face recommends talking to credit unions first because they tend to have lower fees. He suggests comparing offers because some might offer a lower rate but higher closing costs, and vice versa.
You can also shop for a new loan online, which can expand your search and increase your odds of finding the right offer.
Another downside to refinancing is that it can lead to greater long-term costs, even if you’re able to reduce your interest rate. If you only have a few years left on your HELOC repayment and you refinance into a 15-to 30-year mortgage, you will pay interest over a much longer period of time.
Finally, refinancing reduces some of your financial flexibility. A HELOC that is still in the draw period allows you to borrow money if needed, and you lose that opportunity when you refinance. But Face argues that the savings and certainty of a refinance are usually worth it.
What if you’re underwater on your home?
If you’re underwater on your home, meaning the total outstanding balance on all your home loans is greater than the value of your home, you likely won’t be able to take out a traditional refinance. Most lenders require at least 15%-20% equity, and in any case, you won’t be able to borrow more than 100% of the value of your home.
However, you still may be able to refinance through the HARP program if you meet the eligibility requirements.
The HARP program began in 2009 as a way to help people who have little equity or who are underwater on their homes refinance into a more stable and affordable mortgage. There is no cap on how underwater you can be, and the program offers a streamlined process with less paperwork than a traditional refinance.
To qualify, you have to meet a few requirements:
- You must not have had any payments more than 30 days late within the past 6 months, and no more than one within the past 12 months.
- You must be refinancing your primary home, a single-unit second home or a one-to-four-unit investment property.
- Your loan must be owned by Fannie Mae or Freddie Mac.
- Your loan must have been originated on or before May 31, 2009.
- Your loan-to-value ratio must be greater than 80%.
How to qualify for a HELOC refinance
If you’re applying for a traditional refinance in order to retire your HELOC, there are some criteria you’ll have to meet:
- A loan-to-value ratio of 80% is ideal, though some lenders will allow you to borrow with a higher ratio. So if, for example, your home is worth $250,000, having no more than $200,000 in outstanding home debt will put you in your best position to qualify.
- Your home must appraise well enough to satisfy those loan-to-value requirements.
- Most lenders look for a debt-to-income ratio of 43% or below, though some will allow it to be as high as 49%.
- A credit score of 620 is typically the minimum allowed for a traditional refinance, and a score of 740 or above will usually qualify you for your best interest rate.
- You’ll need to prove your ability to pay the loan by documenting your income, savings, investments and other assets.
Other ways to retire your HELOC
Refinancing isn’t the only way to retire your HELOC. There are several other options available to you, each with their own pros and cons.
“The amount of money you owe really decides which route is best,” said Face. “There might be other avenues that you can pay it off less expensive and quicker.”
Here are some options to consider.
1. Pay it off with cash
If you have the cash available to pay off your HELOC now, or if you could save enough money to handle the balloon payment by the time it’s due, that can be the most cost-effective option because you’ll avoid the closing costs that come with a refinance and the interest that comes from extending your repayment period.
An additional benefit is that you’ll likely have to build new financial habits and a better budgeting system in order to make this work, all of which will serve you well in the long run as you move on to other financial goals.
2. 0% balance transfer credit card
If your HELOC balance is relatively low, Face says that you may be able to transfer it to a credit card that offers 0% interest on balance transfers for a limited amount of time.
The big benefit of this approach is that you don’t have to pay interest and can, therefore, pay the debt off quicker.
The big downside is that if you can’t pay it off before the promotional 0% interest period ends, your interest rate can increase substantially, often well above what you are currently paying on your HELOC. For that reason, you need to have a good budget and be sure that you can pay the entire balance in full by the end of the promotional period before going down this route.
3. 401(k) loan
You might hear people recommending a 401(k) loan as a way to pay off your HELOC, but Face warns that this is rarely a good move.
“The rate usually isn’t cheap,” Face said. “You might be paying 6%-7%, and the other thing is that 401(k)s have protections that other assets don’t have if you have to file bankruptcy.”
The other big downside to this approach is that your 401(k) is an investment in your future, and borrowing from it to pay off a debt sacrifices a piece of that future.
Getting out of your HELOC balloon payment the smart way
If your HELOC has entered the repayment phase and the monthly payments are difficult to afford, or if you’re wondering how you’ll be able to make your balloon payment when it comes due, finding some way to retire your HELOC now might be a good idea.
Refinancing your HELOC can allow you to lower your monthly payment, secure a fixed interest rate, stabilize your budget and remove the specter of the balloon payment. It does come at a cost though, and it is usually only worthwhile if you plan on staying in your home for the next few years at least.
Whichever route you take, being proactive and making a plan now instead of waiting until the balloon payment comes due will allow you to make the most of the options available to you and reduce the risk of getting stuck with a payment you can’t make.