When it becomes necessary to come up with a pile of cash, many homeowners see using their house as the easiest and most convenient way. Even those who have other assets can find this avenue appealing because they may not want to sell taxable holdings that will generate capital gains or pay withdrawal penalties on early IRA or retirement plan distributions. Those who borrow on their home equity have three options. The best one for you will depend upon your circumstances and objectives.
Secondary Home Loans: The Landscape
Secondary home loans are divided into three categories:
- Second Mortgages – Also known as home-equity loans, this type of home loan is the most structured and essentially mirrors a primary mortgage. While they can come with variable interest rates, the interest rate is usually fixed and is typically higher than for the first mortgage. These 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. They cannot be drawn upon further once they are issued.
- Home Equity Line of Credit (HELOC) – This type of loan is the most flexible of the three, and there may be no actual funds issued upon approval, although some lines require a minimum initial amount to be disbursed. You then have the ability to draw upon this line of credit when you need it, in the same manner as a credit card. Most lines of credit now come with either a checkbook or a debit card to provide easy access to funds. HELOCs also usually offer future amortization because of their structure, and you will only make payments on the amount that has actually been drawn. And unlike the other two forms of secondary loans, HELOCs usually come with no closing costs. Another option: A loan where you pay only the interest on what you've taken out each month. That can be dangerous because the money you withdrew will be due at the end of the term.
- Cash-Out Refinance – Unlike the other two alternatives, this method does not necessarily involve a second loan, although one is used in many cases to avoid primary mortgage insurance or provide additional funds. In this instance you simply 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.
All three methods of accessing home equity have several characteristics in common. First and most important: Borrowers who don't repay these loans can lose their homes in foreclosure. The interest charged by each type of loan used to be deductible, but with the advent of the Tax Cuts and Jobs Bill, the criteria are different. The interest charged is deductible only if the loan is used to buy, build or substantially improve the taxpayer’s home that secures the loan. If used for those purposes, you can deduct interest on up to $750,000 of borrowing (note that this limit covers all real estate debt; it will be smaller if you also have a mortgage).
How much money you can borrow from your home's equity depends upon how much equity you have in your home. Equity is the difference between how much you owe and how much your home is worth. Lenders use this number to calculate your loan-to-value ratio, or LTV, a factor used to determine whether you qualify for a loan. To get your LTV, divide your current loan balance by the current appraised value.
Of course, the actual amount that is granted depends on your credit score and debt-to-income (DTI) ratio. A credit score of above 700 will probably qualify you for a loan. A little less than 700 may qualify you but with higher interest rates. The qualifying DTI varies from lender to lender, but most require that your monthly debts eat up less than 50% of your gross monthly income. Lenders add up the total monthly payments for your home, including – aside from your mortgage principal – interest, taxes, homeowner's insurance, homeowners' association dues and any other outstanding debt that is a legal liability. Then the debt total is divided by your gross monthly income – base salary, commissions and bonuses, as well as other income sources, such as rental income and alimony – to come up with the DTI ratio. Of course, it is always good to speak with a qualified credit counselor to help you decide whether or not you should apply for a loan.
The Best Fit
The best form of tapping into your home equity probably depends more on what you will need the money for than anything else. Of course, your credit score and financial situation matter too, but they will be a factor regardless of which option you choose. In general, each of these methods are often matched up to the following situations and objectives.
- Home Equity Loans – Because all of the money in this type of loan is disbursed at the outset, most borrowers who apply for them usually have an immediate need for the entire balance. These loans are often used to pay for educational, medical or other lump-sum expenses or to fund a debt consolidation. According to Bankrate.com, the interest rate on home equity loans is around 5.7% as of April 25, 2018; meanwhile, the average APR on a credit card is 16.47% as of the end of March, a record high.
- HELOCs – A home equity line of credit is more appropriate for homeowners who will periodically need access to cash over time, such as for expenses that are incurred on an ongoing basis – for example, a series of home improvements or launching a small business. This is generally the cheapest form of loan, as you only pay interest on what you actually borrow and there are no closing costs. Just be sure that you’ll be able to repay the entire balance by the time the term expires.
- Cash-Out Refinance – This is usually a good idea if you have accumulated substantial equity in your residence and need cash now but also qualify to get a better rate than on your first mortgage. For example, if your credit score is now much higher than it was when you purchased your home, then a lower rate can help offset the higher payment that will come with the new larger loan balance that includes the cash-out amount. And 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 still improve – and your score may rise enough again to warrant another refinance in the future.
The Bottom Line
Using your home as a source of funds can be a smart choice in some situations. Just be sure to carefully run the numbers and anticipate your future cash flow before signing on the dotted line. And, of course, this is only going to make sense if you have enough home equity to begin with. If you don't – or If you can get a better interest rate on a different kind of financing (say, a small business loan or a student loan) – take that option instead.
Home equity debt is not a good way to fund recreational expenses or routine monthly bills. But it can be a real lifesaver for those saddled with substantial, unexpected financial challenges – or who want to invest in their future. The key is making sure you are borrowing at the lowest rate possible and to use the funds for the intended purpose only.
Home-Equity Loans and HELOCs
Refinancing Your Home Equity Loan: A How-to Guide
5 Reasons Not to Use Your Home Equity Line of Credit
How a HELOC Fixed-Rate Option Works
Refinancing vs. Home Equity Loan
Choosing a Home Equity Loan or Line of Credit
Home Equity Line of Credit: 4 Ways to Refinance
Is Your Home-Equity Line of Credit (HELOC) Tax Deductible?