With each mortgage payment, equity is built when you purchase a home. You gain greater ownership over your home as you pay off the principal. This will allow you to access the most valuable asset in your life: the home.
There are three types of home equity financing available: a home loan, a line of credit (HELOC) and a cash out refinance. You can tap into your home equity value to borrow cash immediately. According to Rebecca Neale, a Bedford Family Lawyer attorney in Massachusetts, the type of loan that is best for you will depend on your goals and situation.
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Home equity loan
A home equity loan allows you to borrow a lump sum of money. The maximum amount you can borrow is determined by the value of your home. According to Casey Fleming (a Silicon Valley mortgage advisor and author of “The Loan Guide”), home equity loans usually have a fixed rate of interest. Your loan funds will be paid in one lump sum. You can then spend the money however you like. The loan will be repaid over a specified time period, which is usually between 5 and 30 years.
Home equity loans can be very beneficial to those who have a set goal and fixed costs. A home equity loan is a good option if you are certain that you will need to borrow a specific amount to cover major expenses such as a home renovation project. Neale says that home equity financing is a popular option for clients because it allows them to deduct the interest from their taxes. However, this only applies to home improvement projects.
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Pros
- A fixed interest rate may offer greater predictability
- Payouts can be quite low
- Fixed costs work well
- If you use interest to pay for qualified home improvements, it might be tax-deductible
Cons
- You can apply for a loan to get more money (not revolving credit, like a HELOC).
- If you fail to make your payments, your home could be at risk
- HELOC rates can have higher rates than those offered by HELOCs.
- Home equity line credit (HELOC).
Your maximum credit limit
A HELOC allows you to borrow money on a regular basis up to your maximum credit limit. It’s similar to having a card, but secured with your home. A HELOC allows you to access continuous cash, up to your credit limit, without having to apply for additional funds. This is in contrast to a home equity loan which is paid out one-time. HELOCs usually charge a variable interest rate which fluctuates based upon the prime rate. However, some lenders may offer a lower introductory rate for a limited time.
Fleming states that a HELOC has two phases. There is a draw period which you are required to pay back, and then there is a repayment period. You will only have to pay the interest during the draw period. You’ll be making payments towards both the principal and interest after the draw period ends. You can also make payments to the principal during the draw period. You may be subject to penalties by some lenders if your HELOC is not paid off or closed early. Make sure you check with your lender for their exact policy.
HELOCs can be a great option for those who don’t know how much a project is going to cost and need access to capital at a low rate over the course of a few months or years.
Fleming warns HELOC users. Fleming warns that it is easy to become comfortable during the draw period and never pay towards the principal. He says that you have typically less than 15 years to repay your loan, which can make it difficult to do. The other problem is that you can easily get into a cycle of financing incessantly.
Pros
- Flexible access to money without having to reapply
- Potentially, interest rate could be lower
- Interest tax deductions possible when funds are used to make qualified home improvements
Cons
- If you fail to make your payments, your home could be lost.
- Variable rates may rise in the future
- Refinance with cash-out
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HELOC or home equity loan
Instead of taking out a separate HELOC or home equity loan, you can use a cash-out refinance instead to replace your mortgage with one that is worth more than the amount you currently owe. You could also pocket any difference. Let’s take, for example, $150,000 in mortgage debt. Your home is worth $300,000. A new $225,000 home loan could be used to refinance your mortgage. The new $225,000 mortgage would be used to pay the $150,000 remaining on your existing mortgage. You could also keep $75,000 as cash. The money can then be used for anything you want.
A cash-out refinance can save you money if the refinance interest rate is lower than the original mortgage rate. You may also be able to increase your cash flow by paying a lower monthly amount. If you are looking to borrow some capital for investment properties or consolidate your credit cards, a cash-out refinance may be a good option.
Neale mentions another reason to use a cash-out mortgage: in the event of a divorce. She says that a cash-out refinance can be a great way to get cash to buy your spouse out of their interest in a divorce.
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Pros
- This can be an option if you have equity in your home.
- The interest rates for a HELOC or home equity loan can be lower than those of a HELOC.
- You can potentially increase your cash flow by getting a lower interest rate
Cons
- You could end up in debt for longer than the term of your loan (unless you refinance to a shorter term loan).
- Possibility of losing your home if the new payments are not made
- Private mortgage insurance might be required if your loan-to value exceeds 80% through a cash-out refinance
