The 4 Best Ways to Handle HELOC Balloon Payments

A home equity line of credit (HELOC) is a great financial tool that allows you access to cash using your home's equity as collateral. But there are a few components of a HELOC that can be tricky to navigate, and one of the biggest ones is the large balloon payment that often comes due at the end of the term of the line of credit. This payment can be tens of thousands of dollars or even more. If you've got a HELOC with a balloon payment looming, or even if you're thinking about applying to get a HELOC, here are a few tips to help you handle these large payments.

Before we get into that, let's first review how HELOCs work and how balloon payments factor into them (If you already have a HELOC, feel free to skip the next section.).

Hello, HELOC

A HELOC is a line of credit, backed by your home as collateral. To qualify for one, you'll need to meet the lender's minimum requirements for credit score, debt-to-income ratio, home value and other factors. If you meet those qualifications, you can generally borrow up to 85 percent of your home's value, minus the amount you still owe on the mortgage loan. For example, if your property is appraised at $400,000 and you owe $150,000, you would calculate 85 percent of the total value, which comes to $340,000. Then subtract $150,000, giving you a maximum line of credit of $190,000.

HELOCs function much like a credit card: You can withdraw as many times as you like, within your credit limit (Please note: Some lenders also have a minimum draw amount). As any outstanding balances are paid, the amount of credit available is also replenished. However, this feature exists for a limited amount of time, called the draw period, which varies in length depending on the term set by the lender. During the draw period, you may only be required to make interest payments, but can make additional payments toward the principal if you wish. After the draw period, you either enter into the repayment period, during which you can no longer draw and your required payments increase to include interest and principal, or you reach the due date for the balloon payment, at which time the remaining balance is due in full.

What makes HELOCs attractive to most homeowners is that typically they come with a low introductory promotional interest rate, which generally lasts for one to four years. After the promotional rate ends, the interest rate typically increases to a variable rate, which fluctuates with the market. Over the years, if you have a variable rate HELOC, the interest rate on your loan may change many times—and not always in the direction you want. For example, between December 2016 and December 2018, the Prime Rate (a common index used on variable rate HELOCs) rose from 3.75 percent to 5.50 percent.

How Balloon Payments Work

Sometimes a HELOC is structured with a balloon payment at the end of the loan's term. This is generally because the HELOC is amortized over a longer period of time than the term of the loan, meaning that the monthly payments aren't enough to completely pay off the balance of the loan during the repayment period. At the end, you must make a lump sum payment to pay off the balance of the loan in full. This payment can be sizable, even as large as your entire principal amount.

Suppose you borrowed $50,000 for 10 years at a 4.5 percent interest rate. Your monthly payment would be $253.34 (assuming it included principal and interest), ending with a balloon payment of $43,766.76. Ouch! Calculate your balloon payment here.

Despite the potential financial pain of a large lump sum payment, these kinds of HELOCs do offer the flexibility of making smaller monthly payments initially for access to liquidity you might need.

But sometimes life doesn't go as planned. If a balloon payment is on the horizon and your bank account isn't ready for the shock, what are your options?

Here are a Few Good Ways to Handle Your Balloon Payment:

1. Talk to your lender as soon as possible

If you believe you won't have the money to make a balloon payment, your first step should be to contact your lender and ask about options. The lender may offer a special promotion to move to a new financial product so they can keep your business, work with you to refinance the outstanding balance or lengthen the term of the loan to provide you enough time to pay it off.

2. Convert your HELOC to a fixed rate loan, or another HELOC

If your HELOC loan payments during the repayment period are too large for your liking, a good option is to convert your HELOC into a fixed-rate loan with a longer term. This will give you more time to pay off your balance, and potentially lower your monthly payments. If you still want to have access to an open line of credit, your bank may allow you to pay off your existing HELOC with a new HELOC, which will restart the clock on your repayment window and also give you the perks that come with a new HELOC, including possibly a lower introductory interest rate.

3. Make bigger payments

If the idea of a balloon payment makes you cringe, consider making bigger payments now to either eliminate or reduce the size of your balloon payment down the road. You can amortize the remaining loan yourself by using an online mortgage calculator. Simply plug in the amount of your loan, the interest rate and the remaining length of your loan, known as the term, to find out how much you should pay per month to retire the loan by the end of the term.

True, this method won't give you the smaller, affordable payments that may have been the appeal of the loan to begin with, but it can give you peace of mind to know that you won't struggle to pay off the loan.

4. Refinance Your Mortgage

Refinancing both your outstanding mortgage and HELOC into a new fixed-rate mortgage can help you get some certainty in your housing payment by giving you fixed monthly payments that won't fluctuate. They can also save you money if your existing mortgage's interest rates are higher than the interest rate you can get today.

But refinancing may not be an option if your HELOC is under water, meaning you owe more than 125 percent of your home's value. Lenders require you to have at least 10 to 20 percent equity in your home. And remember that the financial benefits of refinancing will be offset at least partially by closing costs (which can range from 2 to 4 percent of the total refinance balance, including origination fees, appraisal and other services), so it may only be a good option if you plan to stay put in your home for at least a few years, to realize the savings of a lower interest rate. Go over the numbers with an expert loan officer to see if this option makes sense for your specific situation.

No matter which path you decide to take in dealing with a balloon payment, be proactive. Don't wait until the balloon payment is due to start dealing with it. Otherwise, you may be stuck with a payment you can't afford.

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