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 from which to choose, and the best one for any given customer will depend upon their circumstances and objectives. (For more, see: How Interest Rates Work on a Mortgage.)
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 they essentially mirror primary mortgages. 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 dispersed. The borrower then has the ability to draw upon this line of credit when it is needed in the same manner as a credit card, and 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 borrowers 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. Borrowers may also be allowed to pay only the interest on the loan each month, but the entire remaining balance will be due at the end of the term. (For more, see: Home Equity Loans: The Costs.)
- 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, the homeowner simply refinances the home for a larger amount and takes 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, the first and foremost of which is that those who become unable to repay them can lose their homes in foreclosure. The interest charged by each type of loan is also deductible up to the $1 million aggregate limit set by the IRS on Schedule A of the 1040 Form. (Home-equity loans often have an additional per-loan limit of $100,000, so that interest charged on balances in excess of this is nondeductible.) The loan-to-value (LTV) ratio for most secondary loans is usually set at 80%, although this can be higher in some instances for those who qualify, such as for cash-out refinances.
Of course, the actual amount that is granted depends on the borrower’s financial condition and credit score. There are even some types of home loans that can exceed 100% of the LTV ratio, but most financial planners caution borrowers against this form of loan, as they come with a high possibility of foreclosure. Consumers also have certain types of protection with all three types of loans under federal law. Lenders are required to disclose how interest is calculated, the consequences of non-repayment, the terms and interest rate charged by the loan and other pertinent details such as the borrower’s right of rescission.
The Best Fit
The best form of tapping into your home equity probably depends on more on what you will need the money for than anything else. Of course, your credit score and financial situation matter too, but that will be a factor regardless of which option you choose. But in general, each of these methods are often matched up to the following situations and objectives: (For more, see: Reverse Mortgage or Home Equity Loan?)
- Home-Equity Loans: Because all of the money in this type of loan is dispersed 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 to Bankrate.com, the interest rates on home-equity loans is around 4.5%-4.7% as of November 2017; meanwhile, the average APR on a credit card is in the low double digits. (For related reading, see: Is a Home Equity Loan a Good Way to Pay Off my Credit Card Debt?)
- Home Equity Lines of Credit: This is more appropriate for homeowners that will periodically need access to cash over time, such as expenses that are incurred on an ongoing basis, like a series of home improvements or launching a small business. This is generally the cheapest form of loan, since you only pay interest on what you actually borrow and pay 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.
These alternatives are probably not a good idea to use for recreational expenses or routine monthly bills, but they can be real life-savers for those who are saddled with substantial, unexpected financial obstacles – 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.