When they need cash, many homeowners see their house as the easiest and most convenient way to get it. Even those with other assets can find this avenue appealing. They may not want to sell taxable holdings that will generate capital gains. They also might want to avoid withdrawal penalties on early IRA or retirement plan distributions. In addition, because these are secured loans, money you borrow on your home generally carries a much lower interest rate than, say, an unsecured personal loan.
Those who borrow on their home equity have three options. The best one for you will depend on your situation and plans.
- Your home equity can be an excellent source of funds in some situations.
- Second mortgages, home equity lines of credit, and cash-out refinancing are the main ways to tap home equity.
- The smartest way to tap into your home equity depends mostly on what you want to do with the money.
- Home equity debt is not a good way to fund recreational expenses or pay routine monthly bills.
All three methods of accessing home equity have several characteristics in common. First and most important: Borrowers who do not repay these loans can lose their homes in foreclosure. Another similarity is the tax treatment of interest payments. The interest charged by each type of loan was always tax-deductible in the past. However, the Tax Cuts and Jobs Act (TCJA) of 2017 changed the criteria. The interest charged is now deductible only if the loan is used to buy, build, or substantially improve the taxpayer’s home. If the loan is used for those purposes, a taxpayer can deduct interest on up to $750,000 of borrowing. Note that this limit covers all real estate debt, including your primary mortage(s).
Secondary Home Loans: Know the Landscape
Secondary home loans are divided into three categories.
Also known as a home-equity loan, this type of home loan is the most structured and mirrors a primary mortgage. While these loans can come with variable interest rates, the interest rate is usually fixed. The interest rate for a second mortgage is typically higher than for the first mortgage.
Home-equity loans are amortized at the beginning and also have a set term, such as 15 years. Each payment received is divided between interest and principal in the same manner as a primary mortgage. The loan cannot be drawn upon further once it is issued.
Home equity line of credit (HELOC)
This type of loan is the most flexible of the three, and there may be no funds issued upon approval. Some HELOCs, however, require a minimum initial amount to be disbursed. You can then draw on this line of credit when you need it. It works in the same manner as a credit card. Most lines of credit now come with a checkbook or a debit card to provide easy access to funds.
What's more, HELOCs usually offer future amortization because of their structure. You also only have to make payments on the amount that has been drawn. Unlike the other two forms of secondary home loans, HELOCs usually come with no closing costs. Another option is a loan where you pay only the interest each month on what you have taken out. That can be dangerous because all the money you withdrew will be due at the end of the term.
HELOCs are divided into two parts: the draw period, often 10 years, when you can withdraw money up to your line of credit, and the repayment period, when the final amount you withdraw becomes a loan to be repaid with interest, within a specified time period, often 20 years, during which you can no longer draw against the account.
Unlike the other two alternatives, cash-out refinancing does not necessarily involve a second loan. However, it is often used to provide additional funds to a homeowner. In this case, you refinance your home for a larger amount and take the difference in cash. The closing costs for this type of loan can be rather high in some cases because you end up with less equity in your home than you had before, which banks then consider you as a more risky borrower.
Which Is the Best Option?
The smartest way to tap into your home equity depends mostly on what you want to do with the money. Of course, your credit score and financial situation matter, too. However, they will be factors regardless of which option you choose. These choices usually match with the situations and goals listed below.
It is often a good idea to speak with a qualified credit counselor before applying for a loan.
The main advantage of a home equity loan, or second mortgage, is that all of the money is disbursed at the outset. Unsurprisingly, most borrowers who apply for a second mortgage have an immediate need for the entire balance. These loans are often used to pay for educational expenses, medical fees, other lump-sum expenses, or debt consolidation. The interest rates for second mortgages are usually much lower than those for credit cards. Debt consolidation can save money.
Home equity line of credit (HELOC)
A home equity line of credit is a good fit for homeowners who will periodically need access to cash over time. These expenses are usually incurred on an ongoing basis. A HELOC can be used for a series of home improvements, for example, or launching a small business. HELOCs are generally the cheapest type of loan because you only pay interest on what you actually borrow. There are also no closing costs. You just have to be sure that you can repay the entire balance by the time the repayment period expires.
During the coronavirus pandemic, most banks are still offering these loans, but they have raised their requirements for credit scores and loan-to-value ratios. In addition, Wells Fargo and JPMorgan Chase announced freezes on applications for new HELOCs. (The freezes don't affect those who already have HELOCs.)
A cash-out refinance can be a good idea if your home has gone up in value. It is often the best option if you need cash right away and you also qualify to get a better interest rate than on your first mortgage. If your credit score is much higher than it was when you purchased your home, a lower rate can help offset the higher payment that will come with the larger balance that includes the cash-out amount. If you use the cash-out amount to pay off other debts, such as car loans or credit cards, then your overall cash flow may improve. Your credit score may rise enough to warrant another refinance in the future.
The Bottom Line
Home equity debt is not a good way to fund recreational expenses or routine monthly bills. However, it can be a real lifesaver for anyone saddled with unexpected financial challenges. Home equity debt can also be a good way to invest in the future. The key is to make sure that you are borrowing at the lowest possible interest rate.