You’re probably familiar with a HELOC (home equity line of credit). It’s a way to get cash out using your home as collateral, like a credit card. But have you heard of a first mortgage HELOC? Though they’ve been around for about 20 years, they’re less common and less well known for being a twist on the traditional HELOC.
A first mortgage HELOC essentially combines a regular first mortgage with a line of credit, making it the primary loan on a property. Also known as an open-end mortgage, it can be used not only as a source of funding, but also as a cash management tool and a way to prepay your mortgage.
If you’re wondering whether a first lien HELOC is right for you, let’s take a closer look at what makes it different and why it’s worth considering.
How does a First Lien HELOC work?
A first-lien HELOC works similarly to a traditional HELOC: you borrow against your home. But unlike a traditional HELOC, which is a separate debt from your mortgage, a first-lien HELOC replaces your mortgage and is the primary loan against the property. This can make a big difference to creditors if you default on your loan payments. In terms of repayment, a traditional HELOC sits “second in line” behind your primary mortgage. In contrast, a first-lien HELOC is paid off first.
When it comes to accessing your funds, some first lien HELOCs have specific drawdown periods, as do second lien HELOCs, but others, sometimes called “all-in-one mortgages,” allow you to continually tap into the equity in your home throughout the entire 30-year term, and you can also pay off your HELOC at regular, advantageous intervals.
Typically, it works like this: You link your checking account to your first mortgage HELOC A “sweep” feature automatically applies funds to your HELOC balance When you get your paycheck, it’s automatically deposited into your HELOC, reducing your balance This strategy allows you to pay off principal and save on interest every time you deposit your paycheck.
“Every time you get a paycheck or put money into your checking account, by default 100 percent of that money goes toward (your mortgage) principal,” says Michael Crawford, a mortgage loan officer at First Savings Bank, based in Franklin, Tenn. “Just by living a normal life and getting a normal paycheck, every two weeks, every month, whatever, you’re constantly making a mortgage payment.”
This means that you don’t have fixed monthly payments of principal and interest, like with a traditional mortgage. In fact, you don’t pay interest at a fixed rate. Instead, you pay at a variable rate, as is common with home equity lines of credit. First lien HELOC loans use your average daily balance from the previous month to calculate interest.
“If you think about it in terms of a monthly cycle, all your money comes in, then you take money out to pay bills, and the rest of the money that you don’t take out of that income just sits there,” says Anthony Rushing, sales manager and first mortgage HELOC specialist at Indiana-based First Savings Bank. “That’s your principal payment for that month.”
Home loans and first lien loans
Traditional Mortgages | First Lien HELOC | |
|---|---|---|
| interest rate | Repaired | Fluctuating |
| Length of Term | Up to 30 years | Up to 30 years |
| Payment Frequency | monthly | monthly |
| Repayment Period Schedule | Amortize | A lump sum payment may be required |
| Cash Source | no | yes |
| Required payment amount | Principal + interest equal amount | Interest is required, principal is at the borrower’s discretion |
Benefits of a First Lien HELOC
So who benefits from a first lien HELOC? If you have significant equity in your home, a first lien HELOC can give you access to a larger pool of funds than a regular HELOC. It’s similar to a cash-out refinance, but simpler.
“If you’ve worked hard and built up a lot of equity in your home and want access to cash, home improvements, emergencies or other needs without having to refinance, this is the vehicle for you,” says Chad Smith, president and chief operating officer of Better Mortgage, a provider of first-lien HELOCs.
If you want to have a financial hub where all your income and expenses move, a first lien HELOC is also a good option.
“What you’re doing here is funneling cash flow into a home equity line of credit (HELOC), which is a more efficient cash flow management tool,” says John Hatch, senior loan officer at Edge Home Finance, a Minnesota-based mortgage broker that offers first-lien HELOCs. “When you think about a checking account, it doesn’t really have any benefit; it’s just a silly piggy bank.”
“But with a HELOC, all of our income is always working for us — paying off debt, contributing to things like home value appreciation, and then, if we want, we can refinance other debt into the first-lien HELOC,” he adds (a good strategy, especially for high-interest debt like credit card balances).
With financial hubs and loan payments working in tandem, it also doubles as a mortgage prepayment strategy. “A HELOC is a two-way street,” says Logan Hertz, founder of Atlanta-based financial strategy firm Hazeltine, who often advises clients on products offered by lender 1st Lien HELOC. “If you have a mortgage, it’s not a good idea to put all of your income into the mortgage because you’ll never get it back. But here you can do that safely, and so you end up paying down the principal much faster. Your interest rate may be higher, but you’re paying a lot less interest out of pocket, and you pay it off a lot faster.”
Disadvantages of a First Lien HELOC
First lien HELOCs have many benefits, but they’re not right for everyone. One of the most significant risks is the temptation to borrow more than you need. Remember: the average mortgage holder has nearly $215,000 in available equity, according to the latest ICE Mortgage Technology data. If you’re not disciplined, this loan product isn’t for you.
“When you take out a first-mortgage HELOC on your home, you immediately have access to a pretty large percentage of the equity in your home,” Hertz says, “so you need to be the kind of person who can resist the temptation to pull that equity and spend it.”
Keep in mind that interest rates on first-lien HELOCs are typically higher than rates on standard mortgages or cash-out refinances. And because interest rates typically fluctuate, your monthly payment could go up or down depending on how interest rates move. “Over the last two years, with the Fed raising interest rates, lines of credit (interest rates) have risen,” says Smith.
Applying for a first-lien HELOC can also be more complicated. “Typically, lenders will require full title insurance and a full home appraisal,” Smith adds. These are items that are often omitted with a second-lien HELOC. “It’s not necessarily harder, but it’s more time-consuming, there’s more paperwork, and it’s probably a little more expensive.”
Another drawback to a first-lien HELOC is that if you make interest-only payments, your principal balance doesn’t decrease, and you could be faced with a balloon payment toward the end of the loan term. While all HELOCs are secured by your home, missing payments on this type of HELOC increases your risk of foreclosure because, as the name suggests, it’s first in line to be paid.
To prevent this, some lenders require borrowers to meet with a financial advisor or first lien HELOC specialist before closing on the loan.
How to Get a First Lien HELOC
First lien HELOCs are not available in every state in the U.S. and not all lenders offer them, so you’ll need to do some research.
The application process varies from lender to lender. Once you find a lender, you’ll be asked about your goals, including whether you want to pay off your mortgage fast. You’ll need to provide details about your income, expenses, and mortgage balance. A loan officer will then crunch the numbers to see if a HELOC is right for you. After explaining how the loan works and discussing the terms, the officer will review your eligibility requirements with you.
First Lien HELOC Requirements
To qualify for a first-lien HELOC, you need to have a pretty strong financial position — at least as strong as you would for other equity leveraging tools like a cash-out refinance or a traditional HELOC. Generally, you’ll need a FICO score of at least 680, with a score above 700 being preferable. Lenders will also require that you have a debt-to-income ratio of 45 percent or less.
“Banks aren’t going to give these loans to the average consumer so underwriting is a little tougher right now,” said D’Andre Clayton, CEO of North Carolina-based financial-services firm Clayton Financial Solutions.
Lenders also want to be sure that borrowers have sufficient reserves and stable income to make payments and deal with fluctuations in interest rates.
“You have to be on top of your bill payments,” Hatch says, “and tie your checking account to the amount of money you put up as collateral for your home. If you have a credit card with $500,000 in your pocket, you don’t want to spend it irresponsibly and impulse buy a boat or anything like that.”
Amounts vary, but some lenders allow you to access up to 90 percent of your home’s equity with a first-lien HELOC. That means you need to have at least 10 percent equity in your home. There are a few ways to get to that number. “We’ve had people whose homes have increased in value by 23 percent in the last two years,” Clayton says. “We’ve had clients who currently have first-lien HELOCs who haven’t put down 10 percent of their mortgage, and yet their property values have risen enough that they can get a loan.”
First Lien HELOC Conclusion
A first lien HELOC opens up more options for tapping into the equity in your home: Unlike a traditional HELOC, which is separate and secondary to your primary mortgage, a first lien HELOC holds prime status both as a way to tap into the equity in your home and as a way to pay off, or even prepay, your mortgage.
First-lien HELOCs are typically offered to well-qualified borrowers. But it’s not just about meeting the requirements. Because you’re tying a large line of credit to your home, you also need to be in control of your budget and finances. Missing payments puts your home at serious risk.
But with a solid plan, a first lien HELOC can be beneficial, and before you get started, make sure you understand how it works.
