If you are a homeowner who is feeling a bit cash-trapped, there is probably this temptation to tap the equity in your home. Fast-rising home prices have created record levels of equity for U.S. homeowners. So, if your house is worth more than you owe on it, you can tap that equity.
Most homeowners prefer to take a loan against their home equity as it offers them a secured loan which carries a much lower interest rate as compared to an unsecured personal loan.
Those homeowners who borrow on their home equity have three different options. Among them which one is the best, depends on the borrower’s financial situation and future plans.
3 Ways to Tap Home Equity
All 3 ways to access home equity have a number of common characteristics in them. The most important to keep in mind is that borrowers who are not able to repay these loans on time can lose their homes in foreclosure.
The tax treatment of interest payments is another common characteristic of these loans. The interest charged on each type of loan used to be tax-deductible in the past but the Tax Cuts and Job Act (JCTA) of 2017 changed the criteria. Now, the interest charged is tax-deductible only if it is used to buy, build, or improve the tax payer’s home. If the loan is used for these purposes, the taxpayer can deduct interest on up to $750,000 of borrowing.
- Second Mortgage
One of the most common ways of tapping equity is a Second Mortgage which is also known as home equity loan. This type of home loan is very structured and usually mirrors the primary mortgage. While these loans may come with varying interest rates but it usually stays fixed during the loan term. Also know that the interest rate on a second mortgage is typically higher than the interest rate on your primary mortgage.
A second mortgage is amortized at the beginning of the loan. These loans have a set term as well, like 15 years. Each payment received is divided into the interest rate and the principal (just like the primary mortgage). Also, the loan cannot be drawn upon further once it is issued.
- Home Equity Line of Credit (HELOC)
This type of loan is the most flexible among the three, and there may be no funds issued upon arrival. With a home equity line of credit (HELOC), you have a source of funds that acts much like a credit card. You can take multiple loans over the term of the HELOC, typically 10 to 20 years, which is often referred to as “draw period”. Many lenders even issue the borrower a HELOC card, which is very much like a credit card and gives easy access to the money.
HELOCs usually offer future amortization because of their structure. Moreover, you only have to make payments on the amount that has been drawn. Unlike other types of secondary home loans, HELOCs usually come with no closing costs but you may be charged with an annual fee of about $100 or less.
With an HELOC loan, you can borrow up to 75% to 80% of your home equity. These loans are divided into two periods, the draw period and the repayment period. During the draw period, which is often ten years long, you can draw money up to your line of credit. In the repayment period, the final amount that you have withdrawn becomes the loan to be repaid with interest, within a specified period of time (typically 20 years). During this period, you can no longer draw against your equity.
- Cash-out Refinance
A cash-out refinance generally offers the best way to pull out a large amount of cash from the home equity. Unlike the other two types of loans, a cash-out refinance does not necessarily involve a second loan. In this type of loan, you refinance your home for a larger amount, which allows you to take the difference in cash.
The closing costs for a cash out refinance can be rather high because you end up with less equity in your home than you had before.
What is the Best Way to Tap Your Home Equity?
The best way to tap your home equity depends on what you want to do with the money. Of course, your financial situation and credit score also matters a lot. However, these factors will stay there regardless of which type of loan you decide to take.
To give you a better idea, we have classified the common reasons why people take out loans and what type of home equity loan is better under each condition.
Debt Consolidation or Lump-sum expenses
A second mortgage or home equity loan is often used to pay educational expenses, healthcare expenses and other lump-sums. The main advantage of this loan is that all of the money is disbursed at the outset. And, most borrowers who apply for a second mortgage have an immediate need for the entire loan amount.
For homebuyers, who are interested in saving money through debt consolidation, a home equity loan can be a good option. The interest rates for these loans are also usually much lower than for credit cards.
A home equity line of credit (HELOC) is a good loan option for borrowers who will need money periodically over a span of time. These expenses are usually incurred on an ongoing basis. Therefore, an HELOC loan is a recommended option for home improvement projects or even for launching a small business.
HELOCs are usually the cheapest type of secondary loans as you only pay interest on what you actually borrow. Moreover, there are no closing costs. You just have to be sure that you can pay the entire balance by the time the repayment period expires.
Pay off Credit Cards or Car Loans
A cash-out refinance is a good idea if your home value has gone up since the time you purchased it. It is often the best case if you need the cash immediately and you are able to qualify for an interest rate which is lower than on your primary mortgage.
If your credit score now is much higher than when you purchased the home, a lower rate can offset the higher payment that will come with a larger balance which includes the cash-out amount. If you use the cash-out money to pay your other debts, such as credit cards or car loans, your overall cash flow may improve. Your credit score may rise enough to guarantee another refinance in future.
While tapping your home equity is not a good idea to fund your vacations or recreational expenses. It can be an actual lifesaver for homeowners who are caught up in un-expected financial crisis. The key is to make sure you are borrowing at the lowest possible interest rate and have a practical cash flow plan in place for repaying the loan on time.
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