You need to come up with some cash, fast. Maybe you have a leaky roof that desperately needs fixing or you need help paying for your kid's first semester of college. But where do you turn?
If you're a homeowner, you have options that involve tapping into your home equity—the difference between what your home is worth and how much you owe on your mortgage.
There are three main ways to tap into home equity, but sorting through those options can be confusing. To help, we've boiled down what you need to know about some of the most common home financing options—cash-out refinance, home equity loan, and home equity line of credit—and how to determine which one is right for you.
How it works: A cash-out refinance replaces your existing mortgage with a new loan that's larger than what you currently owe—and puts the difference in your pocket. With a cash-out refinance, you're able to receive some of your home's equity as a lump sum of cash during the process.
"This only works if you have equity in your home, either through appreciation or paying down your mortgage," says David Chapman, a real estate agent and professor in Oklahoma.
Pros: If you need cold, hard cash in your hands, a cash-out refinance can help you get it. You can use this money for whatever you want—upgrades to your house, even a vacation. Another positive? If interest rates are lower than when you first got your loan, you'll get to lock in lower interest rates than you're paying now.
"Now is the time to look at a cash-out refinance due to the low interest rate environment," says Michael Foguth, founder of Foguth Financial Group.
Cons: You'll have to pay closing costs when you refinance, though some lenders will let you roll them into your mortgage. The costs can range from 2% to 5% of your loan amount. And, depending on the circumstances, if interest rates have gone up, you could end up with a higher interest rate than your existing mortgage.
Also, you'll be starting over with a new loan and, unless you refinance into a different type of mortgage altogether, you'll ultimately be extending the time it takes to pay off your home loan. Even if you get a better interest rate with your new loan, your monthly payment might be higher.
When to get a cash-out refi
A cash-out refinance makes the most sense if you're able to get a lower interest rate on your new loan. (Experts typically say that at least a 1% drop makes refinancing worth it.)
This option also works well for home renovations, since (ideally) you'll be increasing your home's value even more with the updates. In essence, you're using your home's existing equity to help pay for even more equity growth.
While you could use your cash-out refinance to pay for anything, financial experts typically advise that you spend the money wisely, on something that you see as a good investment, rather than on something frivolous.
2. Home equity loan
How it works: Unlike a cash-out refi, which replaces your original loan, a home equity loan is a second additional mortgage that lets you tap into your home's equity. You'll get a lump sum to spend as you see fit, then you'll repay the loan in monthly installments, just as you do with your first mortgage. The home equity loan is secured by your house, which means that if you stop making payments, your lender could foreclose on the home.
Pros: With a home equity loan, you get a huge chunk of cash all at once. A home equity loan lets you keep your existing mortgage, so you don't have to start over from year one. Your interest rate is typically fixed, not adjustable, so you know exactly what your monthly payment will be over the life of the loan. And, another plus is your interest may be tax-deductible.
Cons: Compared with a cash-out refinance, a home equity loan will likely have a higher interest rate. Home equity loans also come with fees and closing costs (though your lender may opt to waive them). Another downside? You're now on the hook for two mortgages.
When to get a home equity loan
A home equity loan makes more sense than a cash-out refi if you're happy with your current home loan, but you still want to tap into your home equity, says Andrina Valdes, chief operating officer of Cornerstone Home Lending. It can also be handy for home renovations that add value, though of course you're free to use it however you want.
"A home equity loan could be used in cases where you may already have a low mortgage interest rate and wouldn’t necessarily benefit from a refinance," says Valdes.
3. Home equity line of credit
How it works: A home equity line of credit, aka HELOC, is similar to a home equity loan—it's a second mortgage that lets you pull out your home equity as cash. With a HELOC, however, instead of a lump sum amount, it works more like a credit card. You can borrow as much as you need whenever you need it (up to a limit), and you make payments only on what you actually use, not the total credit available.
Since it's a second mortgage, your HELOC will be treated totally separately from your existing mortgage, just like a home equity loan.
"With a HELOC, the homeowner will need to make two payments each month—their mortgage payment and the HELOC payment," says Glenn Brunker, mortgage executive at Ally Home.
Pros: You borrow only what you need, so you may be less tempted to spend this money than a lump-sum home equity loan. You pay interest only once you start borrowing, but you can keep the line of credit open for many years, which means your HELOC can act as a safeguard for emergencies.
HELOCs typically have lower interest rates than home equity loans, and they typically have little or no closing costs. (Again, your lender might offer to waive these fees.) HELOCs are often easier to get because they're subject to fewer lending rules and regulations than home equity loans.
Cons: HELOCs usually have adjustable interest rates, which means you can't necessarily predict how much your monthly payment will be. Most HELOCs typically require the borrower to pay interest only during what's known as the draw period, with principal payments kicking in later during the repayment period. If you don't plan properly or you lose your job, you might be caught off guard by these higher payments down the road. As is the case with other second mortgages, your bank can foreclose on your house if you stop making payments.
"Once a HELOC transitions into the repayment period, the borrower is required to make both principal and interest payments," says David Dye, CEO of Gold View Realty in Torrance, CA. "Many borrowers forget about this transition and are often startled by the sudden increase in minimum payments."
When to get a HELOC
A HELOC makes the most sense if you want the flexibility and peace of mind of knowing you can easily access money in the future, says Mindy Jensen, a real estate agent in Colorado.
"A HELOC is great to have just in case," says Jensen. "You have access to it, but are not committed to taking it or paying for money you don't have an immediate need for."
And compared with an actual credit card, a HELOC has a much lower interest rate, so it's likely a cheaper financing option for you.
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