You don’t hear a lot about people taking out home equity loans these days.
With all the millions of homeowners who got in financial trouble by using their
homes as “ATM machines” to support their lifestyle and the recent massive declines
in home values, home equity borrowing has both gotten a bad rap and become much
more difficult to obtain.
But many homeowners find they still have a need for such loans, to fund major and
necessary expenditures, particularly home repairs or renovations that enhance the
value of their property. And just as important, such loans are still available
for the millions of homeowners who still have equity in the property despite the
declines in housing values the past three years.
Generally speaking, homeowners have three major options for borrowing against their
home equity – a cash-out refinancing, a home equity loan or a home equity line of
credit (HELOC). (Homeowners aged 62 and above have a fourth option, known
as a reverse mortgage, but those are beyond the scope of this article.) Each
has its advantages and drawbacks, depending on the circumstances and needs of the
borrowers.
Cash-out works for those already refinancing
For homeowners who are already thinking about refinancing their mortgage to get
a lower interest rate, a cash-out refinance will probably make the most sense. In
a cash-out refinance, you simply take out a new mortgage to replace your current
one, but borrow more than you owe on the existing mortgage. The excess is
received as a lump sum that can be used for any purpose you wish – you don’t have
to submit a plan justifying your need for the additional money, though the lender
may ask what the general intent is.
A cash-out refinance will generally give you the lowest interest rate of all home-equity
options and the widest choice of loan types as well – fixed-rate, adjustable-rate,
loan terms of 10-40 years, etc. It also means you only have to deal with one
payment a month – no separate payments for your mortgage and home equity loan.
On the downside, the closing costs for a cash-out refinance are considerably greater
than those on a home equity loan or HELOC – closing costs are based on a percentage
of the loan amount and you’re refinancing the entire mortgage. Also, you could
end up extending the term of your mortgage unless you choose a loan scheduled to
be paid off on approximately the same schedule as your current one.
Lower costs on a home equity loan
With a home equity loan, your current mortgage stays in place. Instead, you simply
take out a smaller loan just for the amount you wish to borrow. Closing costs
are much lower than on a refinance, because they’re based on a smaller loan. A
home equity loan also allows you to keep your current rate on your existing mortgage,
which may be an advantage if rates have risen since your first took out the mortgage.
Your interest rate on a home equity loan will be higher than on a cash-out refinance,
but lower than the initial rate on a HELOC. Also, the term on a home equity
loan is typically fairly short – usually, no more than 10 years – so your total
monthly payments are higher than they would be on a cash-out refinance, though you’ll
pay off the extra amount faster. You’ll also have two monthly mortgage payments,
one for your regular mortgage and the second for the home equity loan.
HELOC provides convenience, flexibility
With a home equity line of credit, you’re not actually borrowing any money right
up front – you’re simply arranging to borrow up to a certain amount as needed, in
whatever increments you desire. This can be convenient if you’re planning
several separate projects or if you need to make multiple payments to a contractor
over the course of a project – you only borrow what you need, when you need it.
HELOCs often provide checks or debit cards that can be used to draw on the
account as needed, adding a measure of convenience.
A HELOC provides more flexibility than a cash-out refinance or home equity loan.
For example, if you set up a $35,000 HELOC and only borrow $25,000 against
it, that’s all you pay interest on. But if you borrow $35,000 in a cash-out
refinance or home equity loan and only end up needing $25,000 of it, that’s an additional
$10,000 you’re paying interest and closing costs on. On the other hand, if
you borrow $25,000 through a cash-out refinance or home equity loan and end up needing
more money, you have to arrange for yet another loan.
HELOCs also come with little or no closing costs. However, their interest
rates are substantially higher than on refinances and home equity loans, and are
variable as well, so you could see your payments increase substantially. Like home
equity loans, their terms tend to be relatively short, so they need to be paid off
faster than a full-blown refinance. And because they are open-ended and convenient,
some borrowers succumb to the temptation to draw on them for noncritical expenses
from time to time, piling up debt they may not have incurred if they’d just borrowed
a single lump sum.
Tax-deductable interest
One thing all three types of loans have in common is that interest paid on them
is tax-deductable – as long as they’re drawn against your primary residence and
your total mortgage debt doesn’t exceed the market value. However, there can
be complicating factors if you also have a mortgage on a second home or investment
property, so borrowers in those circumstances should be sure to consult with their
tax adviser first.
Qualifying for any type of home equity loan in the current economic environment
may be challenging. Lenders will likely require that homeowners retain at
least 20 percent equity in their homes in addition to any home equity loan or line
of credit, and will insist on excellent credit as well. In addition, homeowners
in areas where prices have seen unusually steep declines and remain unstable may
have difficulty getting a home equity loan regardless of their personal qualifications,
though this may change as credit markets gradually improve.