What Is A First-Lien HELOC And Who Uses It?

You’re familiar with the HELOC (home equity line of credit): a way to use your home as collateral to access cash, almost like a credit card. But have you come across a first-lien HELOC?

While they have been around for about 20 years, they’re less common, and less well-known. But that may be changing: “Demand for first-lien HELOCs are stronger than ever because homeowners have more trappable equity than any point in history,” says Chad Smith, president and chief operating officer of Better Mortgage, which offers these first-lien lines of credit.  

A first-lien HELOC essentially merges a regular first mortgage with a credit line, becoming your primary loan for the property. Also known as an open-end mortgage, it can not only be a source of funds, but also a cash-management tool and even a way to prepay your mortgage.

How does a first-lien HELOC work?

A first-lien HELOC works similarly to a traditional HELOC: You borrow, using your home to back the debt. But unlike a conventional HELOC, which is a debt separate from your mortgage, a first-lien HELOC replaces your mortgage, becoming the primary loan on your property. That makes a big difference to creditors if you default on the loan. When it comes to repayments, traditional HELOCs sit in the “second position,” behind your primary mortgage. In contrast, a first-lien HELOC gets repaid first.

In terms of accessing funds, some first-lien HELOCs have specific draw periods, like their second-lien counterparts. But others — also known as “all-in-one mortgages” — allow you to continuously tap the equity in your home throughout the entire 30-year term. And also, to repay the HELOC at regular, advantageous intervals.

It typically works like this: You link a checking account to your first-lien HELOC. When you get paid, a “sweep” feature automatically applies your check to your HELOC balance. “When you think about a one-month cycle, all the money goes in, then you take out the money to pay your bills, and then whatever’s leftover, whatever you didn’t pull out from that income, is still in there,” says Anthony Rushing, sales manager and first-lien HELOC specialist at First Savings Bank in Indiana. 

Unless you direct the account to pay a specific amount each month, whatever money is left will go directly toward reducing your principal balance. More often than not, your checking account will be at zero or show a negative balance. That’s nothing to worry about. “It’s built in a way so that it does draw the balance into the negative, but it’s not considered an overdraft,” says Rushing. “There’s no penalty. There’s no fee. It’s just a reflection of what you spent. That night, it sees the negative balance in the checking account, and it pulls money from the HELOC to reimburse the checking [account] back to zero.”

While you could choose not to deposit your entire paycheck, Rushing says the strategy works best when you do. This allows you to tackle paying down the principal every time you deposit your check, saving you on interest. 

Speaking of interest: You don’t have the usual fixed payment of principal and interest each month, as you do with a traditional mortgage. In fact, you don’t pay interest at a fixed rate at all. Instead, as is typical with home equity lines of credit, you pay at a variable rate. The first-lien HELOC loan calculates the interest using the previous month’s average daily principal balance.

“When you think about a one month cycle, all the money goes in, then you take out the money to pay your bills, and then whatever’s leftover, whatever you didn’t pull out from that income, is still in there,” says Anthony Rushing, sales manager and first-lien HELOC specialist at First Savings Bank based in Indiana. “That’s your principal paydown for that month.”

Mortgages vs. first-lien HELOCs

First-lien HELOC benefits

So, who benefits from a first-lien HELOC? If you’ve got significant equity in your home, a first-lien HELOC allows you to access a larger pool of funds than a regular HELOC would. It’s somewhat akin to a cash-out refi, only it “gives homeowners flexibility and speed you simply don’t get with a traditional cash-out refinance,” says Smith.  

“Homeowners who secured a mortgage rate during the pandemic’s historic lows are reluctant to give up their rate and refinance. A HELOC allows them to access that equity without touching their first mortgage,” he notes. “Even with HELOC rates above 9 percent in some cases, they typically still offer a lower rate than a personal loan or a credit card.”

A first-lien HELOC can also be a good option if you like having a financial hub through which all your income and expenses move. “What you’re doing is running your cash flow through a home equity line of credit, which is a more efficient cash-flow management tool,” says John Hatch, a senior loan officer at Edge Home Finance, a Minnesota-based mortgage broker, which offers first-lien HELOCs. “When you think about a checking account, it really gives you no benefits — just as a dumb holding tank, that’s all it is.

“But now, by using the HELOC, what happens is all of our income is working for us all the time. It’s paying down debt. It’s participating in the growth in the value of your house, etc. And then you can, if you want, refinance other debts into the first-lien HELOC,” he adds (an especially good strategy if they’re high-interest debts, like credit card balances).

The financial hub and the loan payment working together can also function as a mortgage prepayment strategy. “The HELOC is a two-way street,” says Logan Hertz, founder of Hazeltine, an Atlanta-based financial strategy firm, who often advises clients on products offered by lender 1st Lien HELOC. “If you have a mortgage, it would not be a good idea to dump your entire income into the mortgage because you can’t pull it back out. Whereas here, you can safely do that. So you end up paying the principal down a whole lot faster. Even though the interest rate may be higher, the interest you pay out-of-pocket ends up being substantially lower, and you pay it off substantially quicker.”

First-lien HELOC drawbacks

While a first-lien HELOC offers many advantages, it’s not suitable for everyone. One of the most significant risks is the temptation to borrow more than you need. If you are not disciplined, this is not the right loan product for you.

“If you take out a first lien HELOC on your primary home, you’re going to have a very large percentage of your home’s equity available to you immediately,” says Hertz. “So you need to be the sort of person who can resist the temptation to just pull that equity and spend it.”

Another challenge? First-lien HELOCs aren’t as widely available as their traditional second-lien HELOC cousins. And when they are available, the borrowing terms can be steeper. “There can be a larger minimum draw requirement, at least $50,000 or 75 percent of your credit line,” says Smith. 

It’ll cost you more to borrow with a first-lien HELOC than with a primary mortgage or cash-out refi, too. “Individual banks set the structure of the loan,” says Rushing. “Generally speaking, you’ll find that interest rates are a bit higher than mortgage rates, about a point higher.” 

The application for first-lien HELOCs can also be more complicated. “Usually the lender is gonna require full title insurance and a full home appraisal,” Smith says — items often skipped for second-lien HELOCs. “That doesn’t necessarily mean it’s harder, but it is more time-consuming, there’s more documentation, and probably a little bit more expensive.”

Another con with some first-lien HELOCs is that if you just make interest-only payments, you won’t reduce your principal balance, and you might face a balloon payment near the end of the loan term. While every HELOC uses your home as collateral, missing payments with this type can put you at deeper risk of foreclosure — because, as the name says, it’s in line to be paid first.

To help prevent this, some lenders have borrowers meet with a financial advisor or a first-lien HELOC specialist before finalizing the loan.

First-lien HELOC requirements

To qualify for a first-lien HELOC, you’ll need to have some pretty strong financials — at least on a par with other equity-tapping tools, like cash-out refinances and traditional HELOCs:

• High score/low debt: While it varies depending on the lender, generally, you’ll need a FICO credit score of at least 680, though a score of 700 or above is preferred.  Lenders also require a debt-to-income ratio no higher than 45 percent.
• Stable income and ample reserves: Lenders want to see that borrowers are financially prepared to make the payments and to handle any interest rate fluctuations. “You have to have a good handle on paying your bills,” says Hatch. “You’re going to be connecting a checking account to whatever size equity line you put on your house. If you’ve got a half-million-dollar credit card in your pocket, you don’t want to be going out using it irresponsibly, like [impulsively] going out and buying a boat, or something like that.”
• Minimal equity requirements: This is the one area where traditional HELOCs are more stringent than their first-lien counterparts. While lenders typically want you to have at least 20 percent equity with a second-lien HELOC, with first-liens, you only need a 10 percent stake. Some lenders also let you access up to 90 percent of your home’s equity.  

Who’s best suited for a first-lien HELOC?

A first-lien HELOC can open up your options for using your home’s equity. Unlike a traditional HELOC, which is separate from and secondary to your primary mortgage, a first-lien HELOC takes the top spot: a vehicle for both tapping your home’s wealth and for paying down, even prepaying, your home loan.

First-lien HELOCs are designed for borrowers who want to reduce their principal payment faster and pay less interest over time. They typically go to well-qualified borrowers. But it’s about more than just meeting the requirements. You’ll also need to be good with your budget and finances since you’re linking a significant credit line to your home — and putting it seriously at risk if you get careless with payments.

But if you have a solid plan, a first-lien HELOC can be beneficial. Just make sure you understand how it all works before jumping in.

FAQ

• What’s the difference between a first- and second-lien HELOC?
  

  A first-lien HELOC replaces a mortgage. A second-lien HELOC exists in addition to a mortgage.

  As their names imply, the main difference lies in their priority in the event of default. As the primary loan tied to your home, the first-lien HELOC is in the number-one position to be paid back. If you fall behind on payments, you could face foreclosure by the HELOC lender, and its claim would take priority over any other home-secured debt. In contrast, with a second-lien HELOC, the lender is in the runner-up position: It would get paid after the primary mortgage in the event things go south with the borrower.

   

• Is a first-lien HELOC tax-deductible?
  

  Yes, since the first lien HELOC replaces your primary mortgage, the interest it charges would be tax-deductible, the same way as your interest on a traditional mortgage would. In most cases, interest is also deductible if you use the funds to substantially improve your property. You must itemize your deductions on your tax return.

• Can I sell my home if I have a first-lien HELOC?
  

  Yes, you can sell your home if there’s a first-lien HELOC on it, as you would if you had a mortgage. However, you have to settle the loan at closing. Typically, you’d pay off the outstanding balance from the sale proceeds and the lien will be removed from the property.