Over the past several years, many fortunate homeowners experienced huge gains in equity as home prices skyrocketed. In less than five years (since the beginning of 2002), the median sales price of a home in California has more than doubled, increasing over $300,000 in price.
How does a homeowner access this equity? You could sell your home, but for most people, that isn't going to cut it. Where are you going to live? If you are keeping your house, the only way to get at the equity in it is to borrow against it.
In this today's article, I'm going to discuss four ways to borrow against your home's equity and how to choose the best way.
Cash-Out Refinance
In a cash-out refinance, your old mortgage is paid off with a larger, new mortgage. The difference between the old balance and the new balance is the "cash out" and is money sent to you.
When interest rates were falling several years ago, it was a boon to homeowners who were simultaneously seeing large increases in their home equity. They could refinance their mortgage, take some cash out, get a lower interest rate and get a lower payment.
These days, the story is a bit different. If you have, say, a 5.25% 30-year fixed mortgage, you aren't going to be able to refinance it at the same rate. While still low by historical standards, rates are a bit higher today, so it's important to understand the full costs of using a cash-out refinance.
Scenario A. Let's assume your current balance is $300,000 on the 5.25% mortgage ($1,312.50 interest per month). You need $75,000, and I help you obtain a new $375,000 mortgage at 6% ($1,875.00 interest per month). The $75,000 does not cost just 6% because you end up paying more interest on the original $300,000. You pay an additional $562.50 per month on $75,000 cash out, equivalent to a 9% interest rate.
Scenario B. If your current mortgage has a 5.75% rate ($1,437.50 interest per month) and you cash-out refinance to a 6% loan, the $75,000 costs an additional $437.50 per month, or a 7% equivalent interest rate. You need to use these equivalent rates to compare to other options.
Home Equity Loan
Another way to access your equity is using a home equity loan, which is a traditional second mortgage. The home equity loan has a fixed loan amount, a fixed interest rate and is amortized over a set number of years, similar to your first mortgage. You continue to make payments on the first mortgage and also make payments on the second.
Home equity loans have slightly higher interest rates than first mortgages because, in the case of foreclosure, the debt is second in priority to the first mortgage, which means greater risk for the home equity lender. If you have good credit and decent equity in your home, you should expect to get a rate somewhere in the neighborhood of 7% today.
Compared to Scenario A, above, the home equity loan is more economical (7% versus 9%). Compared to Scenario B, the home equity loan costs about the same (both 7%). Your particular scenario will be different because of your particular current loan, the amount of cash needed, and the rates you can get on the refinance and the home equity loan (I will be glad to help you with this).
Home Equity Line Of Credit
A second kind of second mortgage is the home equity line of credit, or HELOC. It's a bit like a credit card in that it is a revolving line of credit that you can use, pay down and use again.
If you have good credit and decent equity in your home you can get a HELOC with a rate at prime (currently 8.25%) or less. Compared to Scenario A, the HELOC is a less expensive way to draw on your home's equity than the cash-out refinance, but it is more expensive compared to Scenario B. Your situation will, of course, vary.
The primary benefits of a HELOC are that you don't have to use (and hence pay interest on) the entire credit line, and the monthly payments are typically lower because minimum payments are interest-only for the first 10 or 15 years.
The primary drawback of a HELOC is that it has a variable interest rate, usually tied to the prime rate. Many HELOC holders saw their interest rates rise seemingly without end during the Fed's 17 straight rate increases.
HELOC with Fixed-Rate Lock
Recently, lenders have been offering HELOCs that incorporate the fixed-rate feature of home equity loans. You may lock part of the credit line at a fixed rate and amortization period and do this several times over the life of the HELOC. It's like being able to create your own home equity loans inside of your HELOC, just by writing a check.
The rate for a lock will depend on the amortization period you choose, with a longer period having a slightly higher rate, but lower payments. One nice program has a feature where you can lock for an interest-only period, giving you the lowest monthly payments. Another excellent program is a prime -.25% HELOC that you can currently lock at 6.99% over 5 years, perfect for buying a car.
And, should interest rates decline, you can unlock the lock and go back to paying the variable rate.
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