Having equity in your home means you can tap into it if you should need it. How you tap into it depends on your situation. You generally have two options – a home equity loan or a cash-out refinance. They both have their pros and cons.
The option that works best for you will depend on why you need the money and your current situation with your first mortgage. We’ll cover the pros and cons of each option below.
The Home Equity Loan
A home equity loan is a second mortgage. You take out the equity in your home with a separate loan, making a separate payment. Many banks offer both a home equity loan and a home equity line of credit. The loan offers a fixed rate that you make principal and interest payments on over the entire term. You receive the money you borrow in one lump sum.
A home equity line of credit works much like a credit card. You get a credit line equal to the amount you borrowed. If you draw any funds (use them), you pay interest on that amount only. You are not required to make principal payments. However, if you do make principal payments, you can reuse the funds during the draw period, which usually lasts 10 years. After the draw period, you’ll make principal and interest payments on any outstanding principal.
The Benefits of the Home Equity Loan or HELOC
The home equity loan or HELOC are both second liens. They work best for borrowers that only need to borrow a small amount of money or only need the money for a short period of time. Usually, this means borrowers that know they will move in the next few years.
The home equity loan or HELOC often have much lower closing costs than the cash-out refinance. That right there saves you money. If you are going to move in a few years, it’s hard to justify the higher closing costs when you will not be in the home long enough to make them back in appreciation of the home.
If you only borrow a small amount, the second lien also helps keep your interest payments smaller. If you combine the cash you need with your first mortgage, you’ll automatically pay more interest because the amount borrowed is much higher. Keeping the interest payments small helps keep your costs for borrowing the money down.
Home equity loans usually close much faster than a first lien refinance. Most banks have very few requirements for the home equity loan or HELOC. They don’t have to jump through as many hoops because they keep the loans on their own books – they don’t sell them to Fannie Mae or Freddie Mac. This means you can usually close within the matter of a few weeks, rather than a month or two with a first lien.
The Cash-Out Refinance
A cash-out refinance also has its benefits, especially if you plan to stay in the home for a while after taking the money out of your home.
You may have an easier time securing a large amount of cash if you have the equity in your home with the cash-out refinance. First lien holders go through a much more thorough qualification process. This makes it easier for lenders to give you the large amounts of cash necessary. Taking equity out of your home is a risky move for lenders. If you default, there is very little equity for them to use to their advantage as they try to sell your home. The harder qualification process makes lenders more likely to give you the funds you need.
Oftentimes, the first lien provides a much lower interest rate than a home equity loan. Of course, if you already have a low-interest rate on your first mortgage, you’ll want to make sure you meet or beat that rate. If rates fall low enough, though, you’ll likely get a lower rate on a cash-out refi than you would a second lien.
You may also be eligible to deduct the interest you pay on your first lien, even if you tap into the equity. If you take out a second lien, you are subject to more restrictions and may not be able to deduct all of the interest you pay on the loan, even though it’s a lien on your property.
Lastly, the cash-out option on your first lien often provides a more stable interest rate. Home equity loans, especially HELOCs, often have variable interest rates. This means you won’t know your minimum payment from month to month. Plus, it means you could pay much more in interest than you anticipated when you took out the loan.
As you can see, the loan that is right for you is a personal decision. You’ll have to weigh all of your options, comparing the total interest costs and fees of each loan. Ask your lender for quotes for both a cash-out refinance and home equity loan or HELOC. This way you can see the full cost of each loan over its entirety and make the right decision from there.