By: June Fletcher
Published: September 1, 2011
Determining which type of equity loan to take — second mortgage, HELOC, or cash-out refi — comes down to a number of factors, including why you need it.
When the economy is humming, it´s hard not to see your home as a giant vinyl-sided piggybank. You can borrow against its surging value for anything from a vacation to a college education. But when times are bad and the value of your home falls, you may regret pulling money out of the walls — particularly if you´ve borrowed so much that you can´t cover the cost by selling or refinancing.
Here´s how to start determining whether borrowing against your house in the form of a cash-out refinance, a home equity loan, or a home equity line of credit (HELOC) makes sense for you. Which you choose depends on your circumstances, interest rates, and the purpose of the equity loan. In some cases you might even be better off choosing none of the above.
Here´s how to start determining whether borrowing against your house in the form of a cash-out refinance, a home equity loan, or a home equity line of credit (HELOC) makes sense for you. Which you choose depends on your circumstances, interest rates, and the purpose of the equity loan. In some cases you might even be better off choosing none of the above.
1. Cash-out refinance
In a cash-out refi, you pay off your old mortgage and take out a new one that includes the amount you wish to borrow plus settlement costs. Because it´s a first mortgage, the interest rate is often lower than you´d find on a second mortgage. Just make sure that the lender isn´t adding “junk fees” for things like courier services that are unusually high for your state.
A good rule of thumb: If the cash-out refi´s interest rate is lower than the rate on the existing mortgage, it´s likely to be cheaper to borrow this way than to take out a second mortgage. If it´s higher, retain the lower rate on the existing mortgage and explore other loan options. A typical refi takes two to four weeks once you give the lender the required paperwork.
2. Home equity loan
With a home equity loan, a second mortgage on top of your first mortgage, you borrow a lump sum of money that you pay back over a set number of years, either at a fixed rate or at one that adjusts after a certain period. If you fail to make your payments, the lender can foreclose on your house.
Rule of thumb: Consider this option when you have a good idea of exactly how much money you need to borrow. If you require the money for a new car, for instance, just be sure the terms are more favorable than those you´d get for an unsecured auto loan from a credit union. Settlement costs are similar to a first mortgage, though sometimes a lender will waive some fees if you are paying off an existing first mortgage that you already have with that company. The average closing costs on a $200,000 mortgage are $4,070.
3. Home equity line of credit
A HELOC has an adjustable interest rate that can go up or down when the prime rate moves. Banks use the prime rate as a base to set lending rates — prime plus 2%, for example. HELOCs are open-ended, like credit cards, so you can borrow money up to your credit limit as needed, say, to pay for stages of a home renovation.
Rule of thumb: Shop around for HELOCs that have no annual or cancellation fees and no mandatory average balances or withdrawal requirements. Annual fees can hit $100 or more; cancellation fees, $350 to $500. Like credit cards, HELOCs can be closed by the lenders at any point. If that happens, you lose access to your line of credit. Be prudent about what you borrow. Just because you can borrow up to your credit limit doesn´t mean you should. If you can´t make your payments, you could lose your house.
Is an equity loan right for you?
It´s not hard to calculate, at least roughly, the equity available in your home. Simply subtract the amount you owe from the home´s current market value, as determined by an appraisal or by sales prices of comparable homes. A real estate agent can give you an “opinion of value” to help you pinpoint the price; you might also want to check a website like realtor.com for an estimate of your home´s value.
But remember that as the market changes, so does your home´s equity. Lenders can restrict your borrowing power accordingly. As housing values fell in 2008 and 2009, many borrowers found their HELOCs suddenly frozen, even if they were in the middle of a home renovation.
Easy money was partly responsible for the housing bust, and lenders overcompensated in tightening credit in the aftermath. You can´t do much about either scenario. But you can be proactive about figuring which product is right for your situation.. Any decision should take into account not just how much equity is available, but also your ability to pay it back. Look at your spending habits, your emergency cash reserves (you should have at least six months´ worth), and your credit score. You should dedicate no more than 28% of your gross income toward repaying your home loans.
Unlike credit card debt, all three types of equity loans discussed here are secured by your home, which you may lose if you don´t pay up. Moreover, if you lose your home in a foreclosure or short sale (when a home is sold for less than is owed on the property), you may still be on the hook to the lender for any money that you owe from your second mortgage.
So before committing, be sure to explore other avenues for funding — like tapping savings, applying for a government-sponsored student loan, or borrowing from family or friends — to meet your particular needs.
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